One big problem that individual investors face is that they have to fight the Wall Street machine. With everything from machine-based high-frequency trading to huge information resources at their disposal, Wall Street investment companies make it difficult for regular investors to keep from getting fleeced.
But one way you can fight back against Wall Street is to focus on the areas where it's weak. One such area comes from the incentives that Wall Street money managers get to beat market benchmarks, and the resulting impact those incentives have on the stocks that managers tend to pick.
Do safer stocks do better?
One strategy that has gotten a lot of attention lately involves picking stocks that have relatively low volatility. That makes sense given the wild fluctuations in the stock market over the past several years, which has reminded many investors about the full extent of the risks of owning stocks. Many investors naturally want to look into ways to get a smoother ride.
But one interesting consequence of the look at low-volatility stocks is the discovery that often, they actually do better than their more volatile counterparts. That's a surprising result, because it flies in the face of the long-held assumption that in order to earn higher rewards, you have to take on more risk.
Gambling with your money
One intriguing explanation for this phenomenon comes from a series of blog posts by iShares Investment Research Head Daniel Morillo. Morillo notes that Wall Street money managers have directives in managing client money that don't necessarily result in maximizing long-term returns. Rather, because managers get judged against one of many market indexes and other benchmarks, they obviously want to ensure that their funds beat those benchmarks.
As Morillo points out, it's far easier for managers to produce above-average returns by buying more volatile stocks. Because managers expect the market to rise more often than not, taking on greater total risk can produce better returns even if the stocks that managers select outperform solely because of that higher risk. By contrast, lower-risk stocks may be safer, but managers expect those stocks to underperform their benchmarks, and so managers don't choose low-risk stocks.
This leads to two conclusions. First, most active money managers are given incentives to gamble with your money, so you should think twice before accommodating them. But more important, you can take advantage of Wall Street's aversion to low-risk stocks by owning more of them in your portfolio.
Why low risk feels wrong
Sticking with low-risk stocks seems like it would be easy, but it's psychologically a lot harder than you'd think. That's because typical low-volatility stocks underperform during bull markets, and while they outperform the market during declines, they often still lose money. As a result, you may feel that you never get the returns you deserve -- even if over time, the smoother ride actually produces better overall profits.
But when you actually look at real results of low-risk stocks, you might be surprised. Food stocks General Mills and Hershey (NYSE: HSY), for instance, have the two lowest volatility figures over the past five years in the S&P 500. Yet both have produced total returns over those five years of 50% or more. Altria (NYSE: MO) weighs in with even better returns of more than 130% since 2007. On average, the S&P 500 stocks with betas of less than 0.75 have produced average returns of 54% in those five years.
By contrast, high-risk stocks don't necessarily perform as well as you'd think. Sure, you'll find stocks like Intuitive Surgical (Nasdaq: ISRG), which rode the big wave of its da Vinci robotic surgery systems to gains of 300% in the past five years. But you'll also end up with First Solar (Nasdaq: FSLR), which has suffered huge losses due to worsening conditions in the solar industry. You'll have Genworth Financial (NYSE: GNW), whose insurance operations have had to deal with low interest rates and a financial crisis that hurt profits badly. Add up S&P 500 stocks with betas above 1.5, and you'll get an average return of negative 15.6%.
Don't take dumb risk
Some investors think that taking risk always brings reward. Increasingly, though, that's not the case. Low-volatility stocks may be boring, but they've done a better job of helping make you rich in recent years. Be sure to take a closer look at them in your stock research.
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