How To Beat The Market With Less Risk

(By Christy Heady) You can forget everything you ever learned about stock market risk, because a recent study by The Financial Analysts Journal shows that when you follow one simple premise, you won't have to chase higher returns by taking on a lot more risk ever again. 

In fact, you might be able to sleep better at night knowing that you can actually buck conventional financial theory and instead beat the market and take on less risk. 

With many investors clamoring for safety and feeling like they are living on the edge of a knife lately, unsure which side they will fall off, can this be true?  Can you actually seek safety and returns at the same time?
 
According to this study, you can.

Let's take a look at how this report is not just some esoteric theory, and together look at an example of one investment that applies the concept.


How They Came Up with the Greatest Peculiarity in Finance 

Three gentlemen from various universities in the United States say that low-risk stocks outperform high risk ones (sounds like the beginning of a joke, but I assure you, it's not).  Malcolm Baker from Harvard Business School, Brendan Bradley from Acadian Asset Management, and Jeffrey Wurgler from the NYU Stern School of Business, together found that by grouping 1,000 stocks by market capitalization into either low-volatility or low-beta groups, it resulted in substantial future out-performance.  

They took 41 years of data from January, 1968 to December, 2008 from the Center for Research on Security Prices.  Then, they sorted these stocks into five groups each month according to trailing total volatility or beta and tracked the returns.  Beta is the measure of a stock's volatility in relation to the market, and is one of the most popular indicators of risk.  Volatility is not the same as beta, and is a statistical measure of variance of returns of a security and can also be used to determine risk.

Their results show that by selectively investing in portfolios of either low-beta or low-volatility stocks, the swings were far less extreme than those of the broader market.

Let's use their example of a $1 portfolio over the time period they selected, and see what their results showed:



Why This Exists... And It Will Persist

This idea of low risk stocks outperforming high risk stocks is not new.  But the authors were the first to quantify it in the Financial Analysts Journal and chalk it up to two reasons why their idea works.

First, investors tend to have a lottery ticket mindset on earning returns in their portfolio.  They often seek positions that have the potential, but not necessarily the probability, of receiving a massive windfall.  Meaning, they chase higher-volatility stocks.

Second, mutual fund or pension fund managers have a mandate to beat a specific benchmark portfolio.  They are also supposed to minimize tracking error relative to that benchmark, too.  What that means is that they keep the error margin very thin between how much the return on a portfolio deviates from the return on its benchmark index.  As a result, the authors say, portfolio managers have very little incentive to invest in low-beta or low-volatility stocks because, according to the study, it will increase tracking error.

So if risk is nothing more than betting on the chance that the actual return on an investment will be different than its expected return, is there a way to take on less risk and beat the market?


Seeking Safety and Returns 

A few ETFs over the past year have been created to follow a low-beta/low-volatility approach during these white-knuckle market environments.  One low volatility option is the PowerShares S&P 500 Low Volatility Portfolio (SPLV).  Although there are a few others out there that eke out a bit more return, I like SPLV because it has the most assets under management, has the largest trading volume, and rides out the 100 point-plus up or down days well.

In fact, within its first eight months, about $1.4 billion flowed into the fund.

SPLV carries a beta of just 0.68, with nearly 30 percent of the portfolio's assets in utilities and over 27 percent in consumer non-cyclicals.  Plus, it offers a yield of 2.82 percent.  The fund promises lower volatility, and its expense ratio is low, too:  25 basis points.

Here's how it compares with the S&P 500 since inception:


Taking on more risk in your portfolio to earn higher returns does not have to be a household investment rule.  It used to be that investors could either choose stocks that have the potential for higher returns, or they could ease their anxiety from wild price swings and choose stocks that earn lower returns.

But now that we've seen the results of this study, perhaps we don't really need to make that decision after all.