High Risk, Low Return Paradox

Most of you would have heard that in the stock market one needs to take high risk to earn high returns. All finance classes tell us that as per the Capital Asset Pricing Model, popularly known as the CAPM, the higher the volatility or risk of the stock, higher the expected returns. That is how markets should behave. But is that really how markets behave in practice? Let's look at an anomaly called “The Low Volatility Anomaly”. Because when reality doesn’t agree with theory, its an anomaly. (please get the sarcasm here)

Low Volatility Anomaly

The low-volatility anomaly is the observation that low-volatility stocks have higher returns than high-volatility stocks in most markets studied. In 1972?economist Fischer Black (best known as one of the authors of the famous Black–Scholes equation) presented the Low Volatility Anomaly.

(Portfolios sorted on volatility: US stock market 1929-2020.)

?I know there will be several questions around this.

Does this work in India?

Why does happen in the first place?

Have we been wrongly taught about high risk and high returns?

If so many people know about this anomaly why is it still present and why has it not been arbitraged away?

?All this and more in the coming weeks. But for this week, the main message is high risk is not equivalent to high returns. A well constructed lower risk portfolio in fact delivers higher returns.

?Have a good weekend and enjoy the ride.