Research Highlights
Overturning the Risk-Return Myth
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By Jeffrey Wurgler, Nomura Professor of Finance
In the world of investing, no risk, no reward, right? Not necessarily. NYU Stern Finance Professor Jeffrey Wurgler found that contrary to basic finance principles, riskier stocks (as defined by volatility or beta) have long underperformed less risky stocks.
Wurgler studied the returns of 1,000 stocks over the period from 1968 to 2008 to come up with his anomalous results.
In a published paper co-authored with Malcom Baker and Brendan Bradley, “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly,” Wurgler argues that the anomaly might be partly explained by the fact that almost all actively managed US equity mutual funds are benchmarked to an index. The typical institutional investor’s mandate to beat a fixed benchmark gives it incentives to hold high beta stocks (stocks that do not provide diversification benefits), which leads these stocks to become overpriced and to deliver low future returns.
Wurgler notes that individual investors also tend to overpay for high-risk stocks due to overconfidence, representativeness (focusing on a few well-publicized high-risk stocks with large returns, rather than the greater number of high-risk stocks with low returns) and a tendency to view high-risk stocks as similar to lottery tickets, which offer a small chance of a substantial payoff.
“Investors who want to maximize returns subject to total risk must incentive their managers to do just that,” Wurgler advises. The managers must focus on the benchmark-free Sharpe ratio, not the commonly used {link}information ratio.
Wurgler studied the returns of 1,000 stocks over the period from 1968 to 2008 to come up with his anomalous results.
In a published paper co-authored with Malcom Baker and Brendan Bradley, “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly,” Wurgler argues that the anomaly might be partly explained by the fact that almost all actively managed US equity mutual funds are benchmarked to an index. The typical institutional investor’s mandate to beat a fixed benchmark gives it incentives to hold high beta stocks (stocks that do not provide diversification benefits), which leads these stocks to become overpriced and to deliver low future returns.
Wurgler notes that individual investors also tend to overpay for high-risk stocks due to overconfidence, representativeness (focusing on a few well-publicized high-risk stocks with large returns, rather than the greater number of high-risk stocks with low returns) and a tendency to view high-risk stocks as similar to lottery tickets, which offer a small chance of a substantial payoff.
“Investors who want to maximize returns subject to total risk must incentive their managers to do just that,” Wurgler advises. The managers must focus on the benchmark-free Sharpe ratio, not the commonly used {link}information ratio.