Taking risk hasn’t paid off recently. Since mid-March my no-thought portfolio of high-beta stocks has fallen more than 10 per cent, underperforming the All-Share index by 15 percentage points. Of course, this could be just bad luck. What’s not bad luck, though, is that it continues a long-term trend of underperformance: in the past 10 years it has underperformed the market by over 30 percentage points.
This is by no means the only example of risk-taking not succeeding. In the last 10 years banking and mining stocks have underperformed less risky sectors such as pharmaceuticals and food producers, and indeed defensive stocks generally. And Aim shares have for years underperformed safer mainline ones: since December 1997 they’ve given a total return of just 2 per cent a year (less than inflation) compared with 5.7 per cent on the All-Share.
Taking extra risk, then, often does not pay even over the long-run – be it the market risk of high-beta stocks, the cyclical risk of miners and other value stocks, or the speculative risk of Aim shares.
This fact is not confined to the UK, nor to recent years. Back in 1972 Fischer Black, Myron Scholes and Michael Jensen showed that, in the US, defensive stocks had done better than theory predicted and high-beta stocks worse since the 1930s. Economists at AQR Capital Management have shown that high-beta assets generally underperform over the long-run. And economists at Robeco Quantitative Investments have shown that defensive stocks around the world have outperformed for the past 30 years. Our experience in the UK – where low-beta stocks have outperformed high beta ones in the last 10 years – is thus part of a global pattern.
All this contradicts both common sense and textbook economics, which says there’s a trade-off between risk and return, that we need higher returns to compensate us for greater risk. Of course, risky stocks sometimes do well, such as last autumn when news of a Covid vaccine drove them sharply higher. And of course, risky stocks do badly if risks actually materialise. Over decades, however, such stocks underperform, and do so around the world. That can’t be due to bad luck. It is, though, a hammer blow to orthodox economics.
The best attempt to explain this astounding fact has come from Eric Falkenstein at Pine River Capital Management. Let’s suppose, he says, that people care not about their absolute level of wealth but rather about their performance relative to others.
Such investors can tolerate losing money as long as everybody else does. What troubles them is the thought of missing out on profits that others enjoy. For them, therefore, high-beta and cyclical stocks are safe assets, because they protect them from the danger of missing out on the sort of massive rally we saw last autumn. Conversely, defensive stocks are risky as they carry the danger of missing out on the upside. Because most equities investors are bullish most of the time – they’d not be in equities otherwise – they fear missing out more than they fear underperforming on the downside.
This perspective turns our idea of risk upside down. It is cyclicals and high-beta stocks that are safe and defensives that are risky. And so defensives should outperform over the long-run to compensate for their riskiness.
This doesn’t explain everything: I don’t think it tells us why momentum stocks do so well. But it does solve what is otherwise a puzzle.
But of course, this only works if we really do care about relative rather than absolute returns. Do we?
Fund managers do. Their pay depends upon relative performance: making 10 per cent if the market rises 30 per cent can lose them clients, their bonus and even their job while losing 10 per cent if the market falls 30 per cent will not.
Even for retail investors, though, relative performance matters. This isn’t simply because we want to keep up with the Joneses. If we underperform, we feel stupid and blame ourselves. To pre-empt such feelings we buy speculative assets. Fear of missing out is a genuine motive for some investors.
We’ve other evidence that relativities matter. It comes from the Easterlin paradox – the finding that people’s happiness in developed economies hasn’t much improved since the 1970s despite big rises in real incomes. There are several possible explanations of this, one of which is that what many people care about is not the absolute level of our income but rather our income relative to others.
You might object here that even if many people care about relative performance you are not one of them. If this is the case, you are in a very nice position. You can take on a risk – that of underperforming a big bull market – that troubles others but not you. You can therefore hold defensive stocks and avoid cyclicals and high-beta ones and therefore pick up what is in effect a risk premium. This doesn’t mean day-in, day-out returns, but it does mean better long-term performance.
Beating the market isn’t about being clever, but about having the discipline to not care about periods of underperformance.
