Back to school? PIMCO’s Lahr outlines some ideas on volatility and returns that is in stark contrast to what they teach in modern finance. Time to change the models? From PIMCO.
The most basic concept taught in Finance 101 is the tradeoff between risk and return: Higher risk gives us the possibility for higher returns. As a bedrock principal of market relationships, this concept forms the basis of a number of landmark theories such as the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH).
But practitioners need to beware as these theories may not apply exactly as written when it comes to the relationship between risk and return for individual equities. To state it concisely: If you’re investing in equities, you need to know that lower risk appears to produce the potential for higher returns in the long term. (We measure risk using the periodic standard deviation of stock prices.)
To support what might be an incendiary statement for some, let’s first take a look at a shorter time horizon. Over the trading period of calendar year 2010, we find that volatility and positive returns generally tend to be closely correlated. This is broadly consistent with what you would expect from Modern Portfolio Theory and the EMH. The chart below gives an example of how risk and return interacted over 12 months with an upward moving market. The general relationship implied here is that buying risk typically paid off for the investor in a period where the index was up 10.6%.
Over a year, a stock’s volatility can define its participation in the overall market. More risk tends to amplify the market’s return. So obviously getting the market direction right over a 12-month horizon would likely be very important if you’re making a trade. But over longer periods, our data suggest that lower volatility can lead to higher returns. Why? One reason is that when markets aren’t unidirectional, avoiding downside can have powerful effects on compounding.
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