The conventional wisdom doesn’t fit the data
You can increase your returns by reducing your portfolio’s risk.
I know, I know. That’s directly contrary to what financial planners have always insisted. But this conventional wisdom does not fit the data. Among investment newsletters, at least, the riskiest services have regularly produced some of the very worst returns.
This is well illustrated in the accompanying chart, which focuses on the nearly 300 investment newsletter portfolios monitored by the Hulbert Financial Digest over the trailing decade. The chart plots each portfolio’s annualized performance versus the volatility of its returns (a standard measure of risk).
The chart also includes a trendline that best fits the data; notice that it slopes downward. If risk and return were related in the way that we’ve always assumed, that trendline would slope upward.
Take the newsletter in the lower right corner of the accompanying chart, which has the dubious distinction of being both the riskiest newsletter portfolio monitored by the Hulbert Financial Digest and the worst performer of the decade, losing a heart-stopping 42% annualized. (To make our attorneys happy, we’re not mentioning this newsletter’s name.)
In contrast, the least-risky newsletter portfolio monitored — the one whose dot is closest to the left vertical axis — produced a 3.2% annualized gain over the same period, despite incurring less than 3% of the risk.
Those who invested in the former portfolio could have increased returns dramatically, and nearly eliminated risk, by instead investing in the latter one.
This has big implications for investors and financial advisers alike, since it means that almost everyone can increase their returns without increasing risk, or to reduce risk without forfeiting return.
To be sure, things are more complicated than this. I am being at least partially unfair in criticizing financial planners for insisting that there is a positive relationship between risk and return, since in one sense they’re right: If we focus only on the tiny subset of strategies that have the very best returns, it is indeed the case that you must incur more risk to pick one that holds out the prospect of making more money.
For those who remember taking Finance 101, this tiny subset makes up what is known as the Efficient Frontier, which contains just those few advisers or strategies that, for each level of risk, have made the most money.
The vast majority of strategies are not on the Efficient Frontier, meaning you can increase return, lower risk, or accomplish both by getting rid of them and choosing one that is.
Another reason to avoid particularly risky advisers and strategies is that, even in the best of circumstances, luck plays an outsize role in their track records. And since luck, by definition, is neither all good or all bad, it’s just a matter of time before risky strategies lose big.
Those big losses can prove costly. The percentage gain needed to erase a loss is always larger than the loss itself. For example, a 50% loss must be followed by a 100% gain just to make it back to break-even. A 75% loss must be followed by a 300% gain, and so forth. Pretty soon the odds of such a recovery become vanishingly small.
