High Risk, High Returns?

THE EFFICIENT MARKET HYPOTHESIS suggests that investments are properly priced most of the time, so you’re unlikely to earn superior long-run returns by trying to identify market-beating stocks. This insight, coupled with ample evidence that most professional money managers don’t beat the market, has led many investors to abandon actively managed funds. Instead, these investors have sought to capture the market’s return at the lowest possible cost by buying market-tracking index funds.

What if you want to earn more than the market is delivering? The capital asset pricing model, which assumes efficient markets and which was developed during the 1960s, offered its answer: You need to take greater risk. We’re talking here not about crazy risk, such as betting everything on one stock, but rather risk that can’t be eliminated through broad diversification.

How do you measure this risk? Initially, it was assumed to be captured by a single factor, volatility, which was measured using something called beta. The overall stock market has a beta of 1, but you could potentially raise your portfolio’s beta to, say, 1.1 by favoring more volatile stocks or using leverage. There’s more on measuring volatility in the investing chapter.

Problem is, beta proved to be a poor predictor of returns. Research found that low-volatility stock portfolios generated higher risk-adjusted returns than high-volatility portfolios. In fact, in recent years, there’s been a surge of interest in low-volatility portfolios, prompting the launch of exchange-traded index funds such as iShares Edge MSCI Minimum Volatility USA ETF and PowerShares S&P 500 Low Volatility Portfolio, as well as mutual funds like Vanguard Global Minimum Volatility Fund.

With beta failing as a predictor of stock returns, academics started casting around for other factors that might explain why some groups of stocks perform better than others. Over the past four decades, a slew of research has been conducted on the topic, which has turned up a fistful of factors that appear to be associated with superior returns—and, no surprise here, Wall Street has been quick to capitalize.

Next: Enhanced Indexing

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