June 13, 2024

The Art of Investment

Mastering the Stock Market Strategies

Here’s an investment strategy geared to give you a smooth ride down Wall Street

4 min read

By Mark Hulbert

Why slow and steady really does win the race

Advisers who incur the greatest risk often land near the bottom of the pack.

The key to long-term investment success is being as conservative as possible. That’s just the opposite of what most investment professionals advise. They contend that taking on more risk is more lucrative over a long time horizon. Meanwhile, long-term performance rankings consistently show that advisers who incur the greatest risk often land near the bottom of the pack.

The occasion to focus on the relationship between risk and reward is the publication of a new book entitled “The Missing Billionaires: A Guide to Better Financial Decisions,” by Victor Haghani and James White. It was reviewed in the Wall Street Journal in mid-April.

The book’s core argument is that the statistical relationship between risk and reward is not linear. It isn’t good enough for a portfolio that doubles its risk level to produce twice the performance. To justify double the risk, it would need to produce a return that is four times better.

This argument is not new, as it traces to the groundbreaking work 50 years ago from the famed economist Robert Merton. But, according to Dan Rasmussen, founder and portfolio manager at Verdad, who reviewed the new book for the Wall Street Journal, the rationale “is unfamiliar to most on Wall Street.”

Rasmussen explains: “Consider an investor whose portfolio returns 10% one month and then loses 10% the next month – despite an average return of zero, the investor has actually lost 1% of his starting investment. But if the same investor had experienced twice the volatility – a 20% gain and a 20% loss – he would have lost 4%. Though the average return stayed the same, twice the volatility meant four times the losses. This is called volatility drag – and the authors believe that understanding this concept is the first step towards preserving long-term capital.”

This helps to explain why higher-risk portfolios often not only fail to produce sufficiently greater profit but actually produce lower returns. This is illustrated in the accompanying chart, which plots the 20-year risk and 20-year returns for over 100 newsletter portfolios tracked by my performance auditing firm. Each dot represents a different newsletter model portfolio; notice that the trendline that best fits the data is downwardly sloping. If the traditional story about risk and reward were accurate, this trendline would be upwardly sloping.

By the way, don’t think that this trendline is sloping downwards just because of the two outlier portfolios with the worst 20-year returns – one with annualized return of minus 5.9% and the other with a return of minus 18.3%. The trendline would be downwardly sloping even if these were removed from the chart. Note also that the 20-year period chosen (1996 to 2016) was the last one my firm has available for a large sample of newsletters. Since then, my firm has tracked a smaller sample.

Buffett’s alpha

A decade-old study reinforces this new book’s argument that the path to long-term success involves keeping risk low. That study analyzed the sources of Berkshire Hathaway (BRK.A) (BRK.B) CEO Warren Buffett’s unequalled performance since the 1960s. Entitled “Buffett’s Alpha,” the study was conducted by Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen, all of AQR Capital Management.

Among their findings is that one of the keys to Buffett’s success is favoring conservative “cheap, safe, quality stocks.” By this the researchers mean stocks that are trading for low price-to-book ratios and have low betas, while growing profits at an above-average rate and paying out a significant portion of their profits as dividends. That’s a rare combination, since companies whose profits are growing at a fast clip usually trade for high price-to-book ratios and sometimes pay little or no dividend.

Read: Here’s how much Buffett’s Berkshire Hathaway could make from Apple’s dividend hike

This research and the new book are timely since many are worrying that recent market turmoil could be the beginning of a more severe downturn. In that event, conservative stocks will provide a measure of safety. But, as Buffett’s long-term performance shows, advisers shouldn’t overlook such stocks even if they believe that a major new leg of the bull market is about to begin.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]

More: Sorry, Elon: Warren Buffett won’t be buying Tesla stock

Plus: Stocks and commodities haven’t moved in lockstep like this since 1980. Here’s what investors need to know.

-Mark Hulbert

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

 

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05-08-24 1420ET

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