Study: Lower-Risk Can Mean Higher Reward

Higher risk equals higher reward — it’s one of the tenets of modern portfolio theory. But, reports Forbes’ Daniel Fisher, a new study shows that may not, in fact, be true.

“A new paper in the Financial Analysts Journal turns that assumption on its head, showing how investors can achieve higher returns by buying stocks with lower risk,” Fisher writes. “In fact, investors who consistently assembled low-risk porfolios from 1968 to 2008 earned a tenfold return on their money, after inflation. Those who consistently swung for the fences lost 90% of their money.”

The paper is entitled “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly,” and was written by Malcom Baker of Harvard Business School, Brendan Bradley of Acadian Asset Management and Jeffrey Wurgler of New York University’s Stern School of Business. They cite two main reasons for the phenomenon of low-risk portfolios leading to higher returns, Fisher notes: an “irrational preference for high volatility” and benchmarking.

“This study seems to have important implications for individual investors,” Fisher writes. “The authors urge them to dump the information ratio and focus only on the Sharpe ratio, which is based on volatility without the added complication of benchmark returns. And the next time your stockpicker mentions tracking error, tune him out.”

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