There is no escaping risk in the world of investments. It goes hand in hand with returns. Whether you are investing in corporate bonds, real estate, FDs, or stocks – each of these assets have one or more elements of risk associated. Some are less risky than others, but none are risk-free. And generally speaking, the returns on your investment will be directly proportional to the amount of risk, i.e. the higher (lower) the risk the higher (lower) the returns.
But what exactly is risk? In finance, the measure of risk is volatility or standard deviation, i.e. how much a stock/security tends to deviate from its average price. That is all. It’s not a measure of the likelihood of losing money when making an investment, nor whether a stock is good or bad – it’s simply a measure of the variation seen in the price of an asset.
So can you earn higher returns with lower risk?
Equities is generally considered to be the riskiest amongst all traditional assets (e.g. fixed income, real estate, etc.) because its price tends to deviate a lot more from its average when compared to the others. Which is also partly why it’s proven to be the most rewarding asset to invest in for long-periods of time. And within the equities asset class, there is an entire spectrum of stocks that range from very safe (low price variation) to being super risky (high price volatility).
Most asset pricing theories, including the groundbreaking Capital Asset Pricing Model (CAPM), show a direct relation between returns and risk, i.e. returns increase as you add more risky assets to the portfolio. These theories have helped analysts & investors estimate the fair value of and trade all kinds of assets, yet there exists one phenomena that still cannot be explained by various asset pricing models – it is the observation that less risky stocks (i.e. low volatility stocks) tend to generate superior risk-adjusted returns.
This observation is termed as the Low Risk Anomaly – an anomaly because it goes against the mainstream theories.
Stocks exhibiting this anomaly achieve returns higher than what can be explained by the Efficient Market Theory. In simple terms, these stocks tend to earn a higher return than what they should (or can be explained) for their low volatility level, i.e. they provide higher returns per unit of risk compared to riskier stocks. So while you can’t earn higher returns with lower risk, this strategy is the next best thing since it gives you higher risk-adjusted returns. Let’s take a simplistic example:
- Stock A gave 12% returns on a volatility of 4%
- Stock B gave 20% returns and had a volatility of 10%
- In absolute terms Stock B gave higher returns – but on a risk adjusted basis (risk÷return), Stock A gave a 3% return for each unit of risk whereas Stock B gave only 2% return for each unit of risk.
This anomaly has existed for many decades now, and today investing in low volatility stocks is an established strategy. Which is why we created the Low Risk Smart Beta smallcase in order to exploit this anomaly in the Indian markets. This strategy screens for low volatility stocks amongst the 150 largest & most liquid stocks on the NSE – and the final stocks in the portfolio are weighted based on their volatility levels rather than their market-capitalisation. Firms like Asian Paints, Infosys, Hindustan Unilever, and L&T are included in the current smallcase, making this portfolio ideal for long-term investors looking to beat the Nifty without any unnecessary risks.