What If Higher Risk Leads To Lower Returns?

Authored by Gerald Hwang via Jirisan Capital,

Do you believe that taking riskier equity exposures should reward you with higher returns?

Most finance education is founded on the positive correlation between risk and reward. Taking incremental risk would not be worthwhile otherwise. Over the long run (past 10 and 20 years) global and regional equities have not fulfilled that expectation. In fact, the relationship between risk and realized reward appears to be the reverse of what was expected!

Riskier equities generated lower returns. This result is a two-handed slap in the face for anyone who still believes that markets are efficient. Despite the huge advantage of having excluded the perennial basket cases of Venezuela and Argentina (for most of the decade), the Latin American index rewarded investors with the highest volatility and negative annualized returns. A $100 investment in Latin America would have been whittled down to $87, after having suffered 28% annualized volatility and a worst drawdown of 61% that lasted 9 months.

Performance in EM equities and the Asia region was not much better. If you believe that long term equity returns should surpass that of Treasury bonds, you would have been extremely disappointed with equities as an asset class over the past decade.

Even the S&P 500’s 8.5% annualized return is cold comfort when you consider that the Barcap 20+ year U.S. Treasury Index had a total return of 6.6%. The S&P 500’s realized excess return of 1.9% (excluding tax effects) includes a worst drawdown period of 14 months when the index lost 48%. For those who might point to the superior drawdown management of active equity investors, many active managers performed even worse than that.

Maybe 10 years is too short a time period to consider buy-and-hold horizon returns. What does it look like over the past 20 years? This time, the news is better (but not good!) for the typical MBA curriculum – there is the barest hint that riskier markets generated slightly higher returns.

But the weakly positive slope here is not convincing. Although the next 10 to 20 year period may not have a similar outcome, the risk/return profile over the past 10 and 20 years should make the thoughtful investor rethink the relationship between risk and reward. Over the past 20 years, the realized equity risk premium for the S&P 500 was 0.20%. Yes, that’s right: 20 basis points. In addition to the -48% drawdown experience during the Great Financial Crisis of 2008, the S&P also lost 45% during the early 2000s. I wouldn’t fault anybody for thinking that buy-and-hold equity risk was not worth the heartache. Indeed, a retiree would have to have an almost religious faith that markets will rebound from such a loss. But after demonstrating such faith after the first 10% drawdown, then 20%, then 30%, at what point does faith dissolve in a pool of tears?

Changing our focus to markets operating in regions of highest economic growth, Asian equities returned 8.7% annualized over 20 years, only 1.5% better than the S&P 500, and 1.7% better than the Barcap 20+ year Treasury Index. During this period, Asian equities had two periods of horrendous drawdowns. The first occurred during the late 1990s, when the MSCI Asia ex-Japan Index incurred a 51% loss. During the Great Financial Crisis, it lost 61%.

And in case you wonder how risk vs. return looked over the past 5 years, here it is:

The negative correlation between risk and returns is extreme over the last 5 years. Adding insult to injury: the riskiest markets (Asia, EM, LatAm) benefitted from extreme outperformance in 2017. Asian equities gained 42%, EM gained 38%, and LatAm gained 24%. Such “lottery ticket” type gains may explain global investors’ continued interest in these markets as buy-and-hold investments despite their poor long term track record, extreme volatility, inferior drawdown characteristics, and sub-standard corporate governance.

Those who object that volatility is a poor proxy for risk are correct. Worst drawdowns (i.e. losses from a previous high) are more important for most asset allocators and retirees. Here’s a chart showing returns vs. risk, as quantified by worst drawdown. The strongly negative slope in the relationship between returns and risk should, again, cause long term investors to question what they’re getting per unit of “risk” in these markets, especially when they are on the buy-and-hold bandwagon.

These observations may be of little interest to investors who are locked into a single equity silo (e.g. long only EM equity managers). However, for those with the freedom to hold other asset classes, the material may provide food for thought. Even for die-hard fans of the buy-and-hold philosophy, a nod toward asset dynamism was made by none other than Warren Buffett. He clarified in the 2016 Berkshire Hathaway shareholders’ letter that he isn’t a buy-and-hold investor where public equities are concerned.


hxc GooseShtepping Moron Fri, 03/09/2018 - 19:46 Permalink

You're a real class act.

As for the article, riskier investments generate higher returns WHEN they don't fail. Hence "risk." Besides, FREE markets are very efficient, not perfectly efficient, as they are comprised of humans.

RIGGED markets are inefficient by definition. Intentionally altering the inputs and outputs of freely-made decisions by market actors will always skew said markets away from the most rational way(s) to allocate resources.

In reply to by GooseShtepping Moron

scraping_by hxc Fri, 03/09/2018 - 20:50 Permalink

So, what is this Free Market you speak of and where can it be found?

Any market run by and for capitalists will be a rigged  market. As long as the advantages of cooperation are too obvious, the participants will rig/cooperate/cartel/etc. the markets. Without rules requiring competition, and somebody with a badge enforcing those rules, everyone will ally themselves for maximum advantage.

The Free Market is a fantasy world, like Middle Earth or Narnia. And those, at least the people acting with human virtue are the heroes.

In reply to by hxc

any_mouse scraping_by Sat, 03/10/2018 - 11:21 Permalink

Communism is a fantasy world.

Humans suck at being perfect and working in harmony as one, over a longer timeline than a sports event.

Rules and Badges.

We have lots of rules and lots of badges.

We still have the original problems.

Now we have rules and badges problems in addition to the original problems.

The wealthiest of the wealthy determine the Laws and to whom the laws apply.

The form of the economy/government matters not to them.

In reply to by scraping_by

besnook Fri, 03/09/2018 - 19:09 Permalink

what makes sense about a system that rewards risk averse people who take a .gov job that pays a lot more than a risky private sector job?

Ink Pusher Fri, 03/09/2018 - 19:17 Permalink

Considering that conservatively 80% of the markets are overvalued,oversold and wholly collateralized beyond reality,I would describe everything other than commodities as "Higher Risk" at this very moment.

* Even a few of the aforementioned commodities have become more than risky endeavors....

Dragon HAwk Fri, 03/09/2018 - 19:17 Permalink

lets talk about ALL of the Risks and All of the Rewards. sleeping good at night is a reward, high stress is a negative, spending all your  evenings watching a stock ticker, not so good for your marriage  precious  metals aren't going to go poof, more serenity,   getting stabbed in the back by a business partner you just stabbed last week,  not so good. the shark tanks  are not for everybody, some people prefer pleasant streams, and picnics where people share.

SeaMonkeys Dragon HAwk Fri, 03/09/2018 - 20:09 Permalink

I agree, Dragon HAwk. You understand what's important. 

Too many people buy into the idea that wealth assets in general, and financial assets in particular, are the only things that have value. The truth is a person's social and family life along with their work life are only real things of value. Our shallow idea of society's need for the speculation of the financial markets puts money as a means for profit first and foremost.

The use of money as unit of measurement redeemable in either goods or services useful to productive enterprise is anathema to the speculators who have shaped the last 200 years of Anglo-style capitalism. 

As far as I see it, we as a species have never had real capitalism. We use property rights, not as an incentive for productive behavior, but as a tool for monopoly power. Political capture and fake price discovery go right along with all this.

How could risk and return have any meaningful relationship in a world that finds price completely unhinged from the real economy as it is?

I prefer the pleasant streams you mention!

In reply to by Dragon HAwk

ISEEIT Fri, 03/09/2018 - 19:19 Permalink

Stock markets generally reflect Central Bank activity. Those few voices left willing to cry "capitalist failure" are increasingly being shunned.


Progressivism I can believe in.


Cesare de Borgia Fri, 03/09/2018 - 19:20 Permalink

This is perhaps me being stupid but could it be that the different places in the world have different risk factors in a sense that the S&P 500 will give a higher return in the US for a given amount of risk but the EM Latin America which deals with a whole other bunch of market risk of 4 different countries with Brazil counting for the gross of it and having an aggregate beta of multiple markets being higher than one. Combining it with the shorter term volatility of Brazil going trough a plethora of crises.

I might be making a fool of myself here but if anybody could help me out it would be greatly appreciated. 

Ink Pusher Fri, 03/09/2018 - 19:21 Permalink

Men are about; The " What is " Scenarios...

Women are about; The " What if ? " Scenarios...

From the perspective of this player; I view markets for what they are,not what they were or could be.

romario Fri, 03/09/2018 - 19:42 Permalink

returns were over 70% superior in EM before the currency crisis... of course if you measure them now in dollar strenght, it will be diminished. buy and hold is not that wise, though, when it comes to junk assets

HardlyZero Fri, 03/09/2018 - 20:01 Permalink

Risk measures may be relative, localized, or artificial.

Real risk measures are hard to come across when rates are so low.

Once interest rates normalize we can measure real risk once again with high confidence.

Are markets overextended (for last 10 years...) ?


Real-world existing risk example...that just keeps going:

"Cost for California bullet train system rises to $77.3 billion"   

It's supporting the local economies...but the payoff is far far (ever ?) in the future.

Yen Cross Fri, 03/09/2018 - 20:23 Permalink

  Kind of like a financial singularity moment?

 The point where inflation out strips growth, and purchasing power is meaningless.

 The point where Sovereign debt levels are so high that traders can't differentiate between the nominal gains in equities or bonds?

Anonymous (not verified) Sat, 03/10/2018 - 02:46 Permalink

I'm enjoying the bar-room brawl that goes on in these comments sections.  It's terrifically entertaining as weirdly extreme characters lob their views around as if they're normal.

But honestly I would expect more erudition on the world's #1 blog.  The writing in the blog itself is variously enlightening (finance) and enraging (political) but almost always well-written.  I just wish the reader comments could be its equal.

Or are you just going to carry on swinging digital punches at each other - and to what end?

The Real Tony Sat, 03/10/2018 - 07:41 Permalink

The central bankers that rigged that S&P 500 index since 2009 should be taken out and shot. The index should still be around the 400 level today not 2,770. On second thought shooting it too good for them. The Romans would know what to do with these bankers of today.

any_mouse The Real Tony Sat, 03/10/2018 - 11:48 Permalink

I upvoted.

You are assuming today's FRNs have the same value as 2008 FRNs.

What if the S&P 500 has the same value and the price level is the decline of the FRN's purchasing power?

Truth is it is all crap. Loss of equity value and loss of purchasing power in combination.

Lower quality in everything.

The current cycle started with the FED.

In reply to by The Real Tony