Low Risk, High Rewards: The Low Volatility Anomaly

Axiomatic Memes

It’s an axiom of standard economics that you don’t get above average returns without taking above average risks. No risk, no reward.  It’s an appealing idea, an extension of the entrepreneur's creed: you don't become successful without taking chances.  It’s a meme that’s gone viral, an idea that permeates discussions about investment, drives hard headed analysis and leads us to celebrate the risk taking achievers in society.

And of course it’s a bucketload of hogwash. In fact, lower risk portfolios will tend to outperform higher risk ones.  High risk stocks are dangerous rubbish, and offer not excess returns but excess losses.  They’re a one way ticket to the seedy side of the market.

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Dirty Money: There IS Accounting For Taste

Unfungible People

The link between emotions and decision making, particularly financial decision making, has been recognized for years.  This is a tricky area because the connection between emotions and rationality is difficult to unpick, which is why making investment decisions while in an emotional state is usually not recommended.

To complicate matters, though, it now appears that we associate certain types of money with certain types of emotion, and will only spend such money on certain things.  Which is odd, because the last time I looked money doesn’t seem to be especially emotional: it rarely breaks down and starts sobbing when you try and spend it.  Money is fungible, but people aren’t.

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Behavioral Portfolios

Beer Balancing Behavioralism

Perusing the literature on behavioural finance you might be inclined to the thought that although this stuff is all very interesting and even occasionally amusing it’s not much use when you come to actually investing. It’s a bit like posture – it’s easy enough to point out to someone that they slouch like a sloth with a dose of haemorrhoids, it’s entirely another to explain to them how to retrain their muscles to start balancing pitchers of beer on their head on the way back from the bar.

Digging deeper, though, what becomes apparent is not that we're especially bad at understanding investing but that the way we go about constructing our portfolios is radically different to what theorists expect. Whether it's the theorists who are wrong or the investors is entirely dependent on your perspective. Either way recognising what's going on is an important step on the way to getting a beer balancing musculature.

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