Volatile Stocks Don’t Necessarily Have High Returns

Stocks that are very risky to invest in do not always have high returns as a trade-off due to a studied phenomenon termed the “volatility effect.”

Stocks that are very risky to invest in do not always have high returns as a trade-off due to a studied phenomenon termed the “volatility effect.” Also known as the low-risk effect, it holds that higher-risk portfolios do not reward investors with higher returns.

First studied in 1972, researchers initially found that a higher risk was rewarded with better returns, just not frequently enough. Subsequent research discovered that portfolios with less variance in monthly returns (low risk) had higher average returns than portfolios with more volatility. This was later confirmed by Eugene Fama and Kenneth French in 1992, who found that “the relation between market beta and average return is flat.”

Researchers with investment firm Robeco reviewed the volatility effect and found it universally present in the U.S., European and Japanese equity markets and in emerging equity markets. Their analysis found five explanations for this effect:

Limits to arbitrage that come from shorting and leveraging assets, which causes investors interested in returns to seek out high-beta securities and strengthens the volatility effect by reducing demand for lower-beta securities;
Many investors focus on performance relative to others instead of absolute performance, which increases the effect as investors try to beat the market average;
Asset managers are incentivized to focus on high-risk assets and create option-like rewards for investors in more volatile stocks;
The lottery-like payoff attraction of high-risk stocks causes investors to seek them out because they offer limited downside with the chance at a lot of upside; and
Behavior biases such as attention-grabbing, representativeness and overconfidence that cause investors to prefer higher-risk stocks over lower-risk ones because they’ve either heard of the company in question or believe it will be the next stock to pay off big like a similar stock.

Reviewing the effects on mutual funds, exchange-traded funds (ETFs) and hedge funds, the researchers did not find that the existence of these methodologies significantly impacted the returns from investing in lower-risk stocks. Many mutual funds and hedge funds continue to target riskier assets. At the same time, “ETF investors have zero net exposure to low- and high-risk stocks” in aggregate.

“The Volatility Effect Revisited,” by David Blitz, Pim van Vliet and Guido Baltussen; SSRN, August 2019.