For stockpickers, risk does not necessarily pay. My chart below shows this. It plots price changes for the main FTSE sectors in the last five years against the volatility of their monthly changes in the previous five years. It’s clear that there’s no significant relationship between the two. Yes, you’d have done well if you’d bought into the high-risk IT sector five years ago. But high-risk mining has done poorly, while the low-risk beverages sector has done well, thanks in large part to Diageo.
Overall, there has been no link between risk and return. Which means that defensives offer better risk-adjusted returns than do riskier stocks.
This is no quirk of the last five years. Quite the opposite. It is as close to a general truth as we’ll ever get in the messy world of finance. A new paper by David Blitz and colleagues at Robeco Asset Management finds that “high-risk stocks do not have higher returns than low-risk stocks in all major stock markets”. This has been the case in the US since 1931, in most developed markets recently, and even in emerging markets such as China and India. The fact that low-risk stocks do unusually well in so many different times and places, using different definitions of risk, tells us that this fact is not a mere statistical fluke or data mining. It’s real.
This contradicts both theory and common sense, which tell us that there is a trade-off between risk and return – that we’ve got to speculate to accumulate.
But we don’t have to. Why?
Some errors of judgement might be to blame. Volatile stocks are more likely to rise a lot if only briefly, and so catch our attention and give us the erroneous impression that they are good investments. Also, investors are overconfident about their ability to spot future growth, and so pile into exciting growth stocks causing these to become overpriced and duller ones to become underpriced. And some investors prefer the slight chance of big quick profits to the smaller steady profits from defensives. Just as longshots are overpriced in sports betting, so they are in stock markets – which means defensives are underpriced.
Such explanations, however, run into a problem. If these are the whole story, then defensives should soon stop their relative outperformance. This is because people should eventually wise up to errors of judgement and so correct them.
And yet there is – so far – not much evidence of low-risk stocks’ good performance fading away. This could be because there are other forces behind this performance – ones that won’t go away.
One of these, pointed out by economists at AQR Capital Management, is that many investors cannot borrow as much as they would like. This means that when they are bullish – which is most of the time – they buy high-beta stocks because they regard these as a geared play on the general market. This causes these to be overpriced, and defensives underpriced.
And for many fund managers, stocks with low volatility and low betas are in fact risky, because there’s a danger they will underperform if the market rises sharply, They therefore avoid such shares, causing them to be underpriced.
And, adds Mr Blitz, other fund managers want high-beta stocks in the hope that these will outperform a strongly rising market, thereby putting their fund among the top performers and so attracting more investors. Again, this leaves defensives underpriced.
Explanations such as these suggest that low-risk stocks might well continue to outperform.
Exploiting this fact, however, isn’t easy. We cannot do so in a merely passive way, says Mr Blitz, simply because shares’ volatilities change over time. In the early 1990s, for example, mining stocks were not unusually volatile but recently they have been. And media stocks have recently had relatively low volatility, but had high volatility during the tech bubble and burst.
There’s also the danger that investors might have wised up to a few defensives. I fear that they should by now have learned from Warren Buffett that companies with “economic moats” – sources of monopoly power – have traditionally been underpriced. The good run-ups in recent years in Diageo, Unilever and Reckitt Benckiser might be due in part to investors cottoning on to their past underpricing – in which case, future returns won’t be so good.
These are reasons to investigate defensives carefully, but not for ignoring them. Stockpickers should regard defensiveness in the same way they do value – as something that should at least inform every decision they make.
