Advisers who take on significant risks often find themselves ranking towards the bottom.
The key to achieving long-term investment success is adopting a cautious and prudent approach. That goes against the advice of most investment professionals. They argue that embracing greater risk can yield higher returns over a longer period. Meanwhile, advisers who take on significant risks tend to consistently rank near the bottom in long-term performance.
The publication of a new book titled “The Missing Billionaires: A Guide to Better Financial Decisions,” by Victor Haghani and James White, presents an opportunity to delve into the correlation between risk and reward. It was featured in the Wall Street Journal in mid-April.
The book argues that the relationship between risk and reward is not linear. Simply doubling the risk level of a portfolio does not guarantee a proportional increase in performance. In order to justify a risk that is twice as high, the investment would need to generate a return that is four times superior.
This argument is not new, as it can be traced back to the groundbreaking work of the renowned economist Robert Merton, which was conducted 50 years ago. However, as per Dan Rasmussen, the founder and portfolio manager at Verdad, who reviewed the new book for the Wall Street Journal, the reasoning behind it “is not commonly understood by those in the financial industry.”
Rasmussen explains: “Imagine a scenario where an investor experiences a 10% return on their portfolio one month, only to suffer a 10% loss the following month. Despite the average return being zero, the investor ends up losing 1% of their initial investment.” However, if the investor had encountered double the volatility – a 20% gain and a 20% loss – their overall loss would have been 4%. Despite the consistent average return, the increased volatility resulted in significantly higher losses. Understanding the concept of volatility drag is crucial for preserving long-term capital, according to the authors.
This helps to illustrate why portfolios with higher levels of risk often do not generate significantly higher profits, and in fact, may result in lower returns. This is demonstrated in the accompanying chart, which displays the 20-year risk and 20-year returns for over 100 newsletter portfolios tracked by my performance auditing firm. Every dot represents a distinct newsletter model portfolio. It’s worth noting that the trendline that most accurately represents the data shows a downward slope. If the conventional narrative about risk and reward held true, this trendline would exhibit an upward trajectory.
Just a heads up, the downward slope of this trendline isn’t solely due to the two outlier portfolios that had the worst 20-year returns – one with an annualised return of -5.9% and the other with a return of -18.3%. Even without these data points, the trendline would still show a downward slope. Additionally, it’s worth noting that the selected time frame of 1996 to 2016 is the most recent one that my firm has access to a substantial collection of newsletters. Since then, my firm has been monitoring a smaller sample.
Buffett’s alpha
A study from a decade ago supports the argument made in this new book that achieving long-term success requires minimising risk. The study examined the sources of CEO Warren Buffett’s exceptional performance at Berkshire Hathaway since the 1960s. The study, titled “Buffett’s Alpha,” was conducted by Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen, all from AQR Capital Management.
One of the findings reveals that a crucial factor in Buffett’s success is his preference for conservative stocks that are inexpensive, secure, and of high quality. This refers to stocks that are trading at low price-to-book ratios and have low betas, while experiencing above-average profit growth and distributing a significant portion of their profits as dividends. It’s quite uncommon to find companies with rapidly growing profits that also have high price-to-book ratios and minimal dividends.
This research and the new book are quite relevant given the concerns surrounding the recent market turmoil and the potential for a more significant downturn. If that’s the case, opting for conservative stocks can offer a level of security. However, as Buffett’s impressive long-term track record demonstrates, financial advisors should not underestimate the potential of these stocks, even if they anticipate a significant upswing in the market.
