Home > News > Risk > Is ‘Boring’ Undervalued?
Risk

Is ‘Boring’ Undervalued?

One investment strategist makes his case for why investors should aim for portfolios that keep calm and carry on.

(September 11, 2012) – Sophisticated investors can be seduced by the same risk-return fallacies as lottery ticket customers, argues Societe Generale investment analyst Dylan Grice. 

“The same psychological tendency that overvalues lottery tickets undervalues quality stocks, as their robust business models and solid balance sheets do tend to be quite boring,” writes Grice in his blog Popular Delusions. “So our best guess at the moment is that the mispricing of quality is indeed systematic. It reflects something permanent (our psychological hardwiring) rather than something transient (the fads of macroeconomic theory).”

After pouring through decades of stock market data, Grice and his colleagues found a persistant pattern: On average, returns from high risk investments don’t compensate for the risk an investor takes on. Conversely, very low risk equities tend to pay off disproportionally well. 

Statistical reasoning is like a magnetic compass: When probabilities approach polarity–if an outcome is extremely unlikely or near-certain–our perception of risk goes haywire, he argues. That’s why people buy lottery tickets and penny stocks, despite the outsized chance of losing their investment. 

Want the latest institutional investment industry
news and insights? Sign up for CIO newsletters.

In Grice’s view, people value certainty so highly—100% is vastly more comfortable than 95%—that near-certainty can be had for cheap: “We undervalue near-certain outcomes. Yet this is exactly the world in which low beta/high quality stocks live…And if high beta/low quality stocks live in the world of possible triple-digit returns, attracting lottery ticket overvaluations, low beta/high quality stocks live in the world of near certainty, attracting the boredom discount.” 

This theory dovetails with the low-volatility investment anomaly: “All ‘true’ low volatility portfolios should earn a premium return of about 2% in the United States and do so with 25% less absolute risk than the benchmark,” says one leading strategist. “Even something as simple as screening out high volatility stocks and weighting by the inverse of volatility (i.e., allocating more to low volatility stocks) will produce a comparable result.” 

While penny-stock traders pay a premium for the thrill of a slim chance, what’s the converse—the psychological effect of near-certainty that investors are eager to buy their way out of? “Slightly anxious boredom,” says Grice.

Read Grice’s whole paper here.

Home > News > Risk > Taking the Long View on Low Vol
Risk

Taking the Long View on Low Vol

Before committing to a low-volatility strategy, a leading strategist advises, investors must first commit to ditching short-term evaluations and relative risk benchmarking.

(September 11, 2012) – While most chief investment officers dislike much attention being paid to their funds’ quarterly and one-year returns—institutional investing is a long game, after all—some judge their outsourced managers on those very timelines. 

But any CIO considering a low-volatility strategy had best apply their long-range perspective to external managers as well, according to equity strategist Ryan Larson, who recently published a guide to low-vol with Research Affiliates. 

“Because of high tracking error,” Larson writes, “successful low volatility investing must throw out any comparison to relative risk measures such as the information ratio”—the ratio between excess return and tracking error. 

Take the last couple of years, for example. A low-vol portfolio’s performance, measured via information ratios and other relative risk benchmarks, would have bordered on bipolar: During 2011 low-volatility stocks outperformed the broad stock market by 10%, then in the first quarter of 2012 they lagged by 5%, and outperformed again in the following quarter by 5%. As Larson writes, “What a seesaw!” 

Never miss a story — sign up for CIO newsletters to stay up-to-date on the latest institutional investment industry news.

And external managers’ fates are often tied to the information ratio: “Three years is typically the longest boards allow a manager to underperform the market before pulling the plug. Portfolio managers are a self-preservation-oriented bunch, so they began to manage their portfolios with an eye on the index and toward minimizing relative risk (tracking error), with less concern for absolute risk (standard deviation).” 

Low-volatility strategies can offer substantial rewards: by Larson’s calculations, they earn a near one-to-one ratio of return to risk, whereas cap-weighted S&P 500 investors shoulder twice the risk for the same return. 

Making—or perhaps allowing—these strategies work is all a matter of perspective: “It is very difficult for a single portfolio approach to be both a relative risk and an absolute risk winner. The more one wants to shift from a relative approach to an absolute one, the more one will have to screen out large portions of the market and, accordingly, accept more tracking error.” In return, the low-vol investor should get, well, returns. 

Read Larson’s full paper here.

«