Higher Risk Not Equal to Higher Returns

We’ve covered this in the past, but there’s new research. A rule of thumb is that you have to take more risk to earn higher returns. It appears now that in stocks at least that’s not the case. In fact, the riskiest stocks, as measured by volatility, earn lower returns than average.

One explanation could be that investing has changed. In 1980, individuals owned 48 percent of stocks. By 2007, that proportion had dropped to 22 percent. The vast majority of stock is now owned by large asset managers: hedge funds and mutual funds that employ professionals to pick stocks. A paper from Paul Woolley and Dmitri Vayanos, both of LSE, and Boston University’s Andrea Buffa argues that the way fund managers are judged and paid has altered how markets function.

A fund manager’s performance is judged according to how well a fund does in comparison to a benchmark, often an index such as the Standard & Poor’s 500-stock index. Because underperformance means losing assets, and beating the market is extremely difficult, most managers respond by hewing pretty close to their benchmark. For example, managers might believe that a stock is overvalued but feel compelled to buy more of it—which would further drive up prices, making the stock more volatile.