Some of the stock market losses you have suffered this year have been in vain.
I know this will be a big blow to those of you who have invested in riskier stocks in the belief that you have to take that extra risk to have a chance of greater returns. Even though you are affected by your huge losses, at least you were able to console yourself with the belief that you had no choice but to take those risks.
But you did have a choice; your losses were largely avoidable. This is because, contrary to conventional wisdom, higher-risk stocks do not usually yield above-average returns.
That doesn’t help you much with the losses you’ve already had, of course, as they are water under the bridge. But a correct understanding of the historical relationship between risk and reward will allow you to prepare for the next stock market volatility attack, whenever that happens.
See the attached chart, which represents the risk and annualized returns of each of the investment bulletin portfolios overseen by Hulbert Financial Digest from 1990 to 2009. I chose to focus on this 20-year period because it includes two powerful bulls. markets (1990-1999 and 2002-2007) along with two main bear markets (2000-2002 and 2007-2009). If risk and reward were related in the way that conventional wisdom would have us believe, the trend line that best fits the data would be tilted upward.
It doesn’t. Note that, but for newsletters at the conservative end of the spectrum, for which there is a slightly upward sloping trend line, this trend line is sloping down. (The trend line in the attached graph is a quadratic polynomial, drawn by Excel.)
You might object to this analysis arguing that he is little more than a Monday morning quarterback on my part. But this is not true. I have presented a similar chart and analysis on many previous occasions, and in each of them I urged you to reduce the risk instead of waiting for a bear market to start.
Long-term evidence
You may also be wondering if my analysis was based on selected data. Would other periods in the history of the stock market paint the same picture?
The answer is definitely yes, according to the recently published research by Guido Baltussen, Bart van Vliet and Pim van Vliet of Robeco Quantitative Investments in the Netherlands. (Baltussen is also a professor of finance at Rotterdam’s Erasmus University.) For their study, entitled “More than 150 Years of Conservative Investment: Winning to Lose Less,” the researchers looked at a unique database of US dating back to 1866. For each month thereafter, they ranked the shares in 10 portfolios of the same size based on their 36-month volatility. The attached graphic (reproduced from Robeco’s website) summarizes what they found.
Notice the striking similarity between the shapes of the Robeco trend line and the shapes of the investment bulletin chart. “In general,” the researchers note, “this informs us that taking more risks is not necessarily rewarded in the long run.”
The implication of investment is clear: on an equal footing, you should encourage lower risk stocks. About the riskiest. You will sleep more easily at night, and over time you should earn almost as much money, or more, as the riskier stock portfolios that produce exceptional returns when the market goes its own way and then lose most. of these gains when the market turns against them.
Making almost as much money, even if you sleep more easily, is a winning combination. Unless you’re an emotion seeker, this is a no-brainer.
Mark Hulbert is a regular contributor to MarketWatch. Your Hulbert Ratings keeps track of investment bulletins that pay a flat fee to be audited. You can contact him at mark@hulbertratings.com