Over his long career, Professor Robert Haugen has been an advocate of quantitative investing in general and low-volatility investing in particular. He has been an outspoken critic of the assumed positive relationship between risk and return and was among the first to critically test the Capital Asset Pricing Model almost 40 years ago and to find it wanting.
Haugen and his co-author, A. James Heins documented the lack of a positive relationship between risk and return in the empirical cross-section of stock market returns for the first time in 1972. Over the past four decades, he has continued to contribute consistent evidence of a negative relationship between risk and return, including studies across different time periods, regions and asset classes.
His latest research, written with Nardin Baker, looks at stock prices around the world over more than 20 years. Their conclusion? “We looked at the payoff to risk over 21 years in 17 countries and found it was negative in all individual countries,” said Professor Haugen. “High risk stocks only outperform low-risk stocks for very brief periods of time on a rolling three-year basis.” One such brief period was during the IT bubble, he said, before quickly noting “but high-volatility hardly ever outperforms.”
The data is stunning. “Across all countries, the difference in return between the highest-risk and lowest-risk decile portfolios is 19.4%. If you ranked these stocks based on the return slope, you would see how the higher the risk, the lower the returns. And the difference in return volatility (17.9%) shows that stocks with high volatility in the past will continue to have high volatility in the future.”
Haugen believes the evidence is overwhelming in support of low-volatility investing. “This is all you need,” he said, “case closed.”
With empirical evidence persuasively documenting the presence of the volatility effect, Haugen’s advice to investors is to “go west” in the mean-variance space to pursue the returns available from low-risk stocks. He compared the opportunity in low-volatility investing today to the US pioneers of the 1800s, who headed west to the cheap land and open spaces of California. “The price of land went up and up, and this is what will happen to you…Get there fast. Be a pioneer.”
But how long will the anomaly last? Haugen believes it existed “long before” 1926, which is the earliest it can be documented based on the availability of historical stock market data. And he believes it will continue to persist because of the agency effect and human nature.
“Human beings were the same in 1926 as they are now,” he said. “They are still trying to impress each other and their clients. They are still sending their clients into high-volatile stocks.”
He found that institutional investors hold a large portion of high volatile stocks. These are stocks that receive intense analyst coverage and are often in the news. This tendency, he says creates demand, forcing up the prices of high-volatile stocks now and in the future.
While he does not believe there is an end in sight to the volatility effect, he believes it would be a good thing if it did end. “I’m not in this for the money,” said Haugen. “I want the market to correct its mistake.”
“Think of the damage that has been done by modern finance and the trillions of dollars moved into index funds that are dominated by growth stocks. All of those people could have had a much better retirement.”
“I am sitting here as an old goat, because it took you so long to realize I was right after all.”