Home Investing Strategy Return on investment: Does taking high risk lead to a higher return on investment?

Return on investment: Does taking high risk lead to a higher return on investment?

by WOOWinvest
0 comment
Return on investment: Does taking high risk lead to a higher return on investment?

One of the most popular theories in finance is that higher risk leads to higher returns. It forms the basis of theoretical finance – something taught widely in classrooms, courses and business schools.

Why is this true?

According to theory – stocks with higher volatility need to provide investors with higher returns to make up for the higher risk they take. According to this theory, financial experts tend to calculate expected returns on specific securities, and almost always, those with higher volatility tend to have higher expected returns.

But is this true in reality? yes and no.

Why is it? Different asset classes (gold, debt, stocks) follow this theory. For example, stocks as an asset class tend to be more volatile than debt. Historically, stocks have had higher long-term returns than debt-related securities.

why not? When it comes to volatility, stocks don’t exhibit the same behavior. Many studies have shown that stocks with higher volatility do not show higher returns than stocks with lower volatility. This is perhaps one of the greatest anomalies in modern finance.

Stock market enthusiasts tend to trade high-volatility stocks in the hope of making big bucks, but the reality is that low-volatility strategies not only work, but outperform most strategies in terms of long-term returns.

What is a low volatility strategy? This is a strategy where investors can buy and hold stocks that have long-term volatility or long-term price stability. Empirical evidence from other developed markets such as India and the US suggests that investing in low-volatility stocks reduces portfolio risk and increases investor returns. Additionally, it has historically outperformed the Nifty and S&P500.

alien contributors

Why is this happening? The main reason this holds true across regions is mainly downside protection for low volatility strategies. This means that low-volatility stocks tend to fall less when the market enters a bear market or crashes.

Table 2alien contributors

By cutting losses in a weak market, the strategy needs to do less to beat other strategies or benchmarks during the recovery phase.

Let’s take an example. A fund that loses 10% needs 11% to recover. A fund that loses 50% needs a 100% gain to get back to its original price. The returns are asymmetrical. In this case, any strategy that provides downlink protection can be very effective to recover faster and provide better performance.

table 3alien contributors

Additionally, investors large and small tend to like stocks with high volatility. High volatility stocks offer hope of better performance. High volatility stocks tend to be overbought and therefore more expensive than low volatility stable stocks. Better valuations for low-volatility stocks make way for better investment performance in the long run.

Table 4alien contributors

What about the bull market? In bull markets, low volatility strategies tend to underperform. The trick is to hold the fund during good and bad cycles to fully benefit from the strategy.

In conclusion, a low volatility strategy may be counterintuitive, but it has been shown to help investors fight volatility and provide good returns. Investors looking for equity funds but concerned about market volatility can use low-volatility strategies to add to their portfolios. This strategy is most effective during market crashes and can be used as a low-cost ETF or index fund.

So next time someone talks about high risk equals high reward, keep in mind that it may not be true!

(The author is Motilal Oswal AMC Head of Passive Funds and CEO of Glide Invest.)

You may also like

Leave a Comment

Our Mission is to help you make better trading decisions by providing actionable investing content, comprehensive tools, educational resources and assist you in making more money in the stock market.

Latest News


Subscribe my Newsletter for new blog posts, tips & new photos. Let's stay updated!

@2022 – All Right Reserved. Designed and Developed by WOOW Invest

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More

Privacy & Cookies Policy