Does taking high risk lead to higher investment returns?

Why is this true?

As per theory – stocks with higher volatility need to deliver higher returns to investors to compensate for the higher risk taken. According to this theory, finance experts tend to calculate expected returns of a particular security, and almost always, expected returns tend to be higher for those with higher volatility.

But is this true in reality? Yes and No.

Why yes?

Different asset classes (Gold, Debt, Equity) follow this theory. For example, equity as an asset class tends to be more volatile than debt. Historically, equity has had greater longer-term returns than debt-related securities.

Why No?

Stocks do not show the same behaviour when it comes to volatility. Many studies show that stocks with higher volatility do not exhibit higher returns than stocks with lower volatility. This is perhaps one of the biggest anomalies in modern finance.

Stock market enthusiasts tend to trade high volatile stocks in the hope of making large sums of money but the reality is that a low volatility strategy is not only effective but beats most strategies in terms of long-term returns.

What is a low-volatility strategy?

It’s a strategy where an investor can buy and hold stocks that exhibit low long-term volatility or long-term price stability. Empirical evidence in India and other developed markets like the US have shown that investing in low volatile stocks could reduce risk at a portfolio level and increase returns for the investor. Moreover, it has demonstrated historical outperformance compared to Nifty and S&P500.

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Why does this happen?

The big reason why this holds true across different geographies is primarily due to downside protection in low volatility strategies. This means that when a market enters a bear market or a crash, low volatile stocks tend to fall less.

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By losing less in weak markets, the strategy needs to do less in the recovery phase to beat other strategies or benchmarks.

Let’s take an example. A fund that loses 10% needs 11% to recover. A fund that loses 50% needs 100% gain to return to its original price. Returns are a consequence asymmetric. In this scenario, any strategy that gives downside protection can be highly effective in recovering faster and delivering better performance.

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In addition, investors big and small tend to like high volatile stocks. High volatile stocks offer the hope of better performance. High volatile stocks tend to be overbought and hence more expensive than low volatile stable stocks. Over the long run, better valuations of low volatile stocks make way for better investment performance.

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What about bull markets?

A low-volatility strategy tends to underperform by a small margin in bull markets. The trick is to hold on to the fund across good and bad cycles to benefit from the strategy thoroughly.

In conclusion, a low volatile strategy can be counter-intuitive but has shown that it helps investors battle volatility and offer good returns. Investors looking for an equity fund but worried about market volatility could use a low volatility strategy to add to their portfolio. The strategy is most effective during market crashes and is available as a low-cost ETF or an index fund.

So the next time someone talks about higher risk equals high return, remember it simply may not be true!

(The author is Head of Passive Funds at Motilal Oswal AMC and CEO, Glide Invest.)