Does Lower Risk = Higher Long-Term Equity Returns?

With both bulls and bears now having valid points about what the future may bring, I decided to title this Blog to spark a little debate about how the industry discusses risk and return in the equity market.

As I say on the website, SJM feels that healthy banter about what are sometimes provocative ideas leads to better decisions.  In the investment world, this can be even more important as a trade always has two sides (willing buyer and seller).  At the end of the day, we all need to be careful to not get trapped in a debate loop and non-action.  You have to move forward and take actions that you feel are appropriate, but why not take a little time to look around and sometimes explore the road less traveled.

Before I go much further, I want to give full credit to a white paper that PIMCO published back in January 2012.  Re-reading their piece this past week is what drove me toward what might be a heretical title question (yes, this is a question) to those who are close followers of the Capital Asset Pricing Model (CAPM) theory and Effecient Market Hypothesis (EMH) (yes, also notice the words theory and hypothesis).

Please consider taking time to read the full report at the below link.

PIMCO Insights – Stock Volatility: Not What You Might Think

In the hope that you will still click on the above link to get the full story, in short I feel the PIMCO study supplies a new theory and the following questions that should be considered.

Over the long run, do low volatility stocks lead to higher returns because they have lower downside risk and hence allow for greater compounding by avoiding the larger negative returns that higher volatility stocks can produce? (The PIMCO research lists some compelling charts to make this case in both Developed and Emerging Markets.)

Do human behavioral traits such as overconfidence and herd mentality amplify the potential negatives of high volatility stocks because we are likely to make the wrong timing decisions and get into higher volatility stocks later in a cycle and closer to their larger downturns relative to low volatility stocks?

Do incentives in the investment industry drive some firms and professionals to take larger risks because bonuses can be higher if they hit one out of the park in any one year? (keep in mind that these comments are echoed by PIMCO who is a firm that has to deal with these issues)

As PIMCO also concludes, I feel their data suggests that lower risk may lead to higher returns for long-term equity investors.  I think this might be compounded based on my belief that smoother rides generally allow both individuals and institutions to feel more comfortable sticking to long-term plans, which then creates better opportunities to achieve individual goals.

In all of this, I am not suggesting that the higher risk higher return graphs we have all grown up with be thrown out, and I am not trying to take a bearish position.  I am also sure that others can come up with charts to debunk some of what PIMCO published.  I just think we might need to think outside the box a little more and be open to different ways of evaulating risk and return when discussing equities.

This is sure to get a few e-mails, which I welcome.

Enjoy and, importantly, try to stick to your long-term plan.

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