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Low Risk Stocks Outperform within All Observable Markets of the World

Last Updated on 10 February, 2024 by Rejaul Karim

In the vast tapestry of global markets spanning from 1990 to 2011, Nardin L. Baker and Robert A. Haugen unravel a compelling anomaly—The Low Volatility Anomaly. Across 33 diverse markets, their study scrutinizes the consistent outperformance of low-risk stocks over their high-risk counterparts.

Delving into an international array of stocks, their approach is intentionally transparent and replicable. Surpassing traditional Sharpe ratios, low-risk stocks emerge as victors in both the collective universe and individual countries.

The authors posit that agency issues, particularly compensation structures and internal stock selection processes, contribute significantly to this phenomenon. By challenging the conventional wisdom of CAPM and the Efficient Market Hypothesis, this study reshapes our understanding of risk and return dynamics on a global scale.

Abstract Of Paper

This article provides global evidence supporting the Low Volatility Anomaly: that low risk stocks consistently provide higher returns than high risk stocks. This study covers 33 different markets during the time period from 1990-2011. (Two previous studies by Haugen & Heins (1972) and Haugen & Baker (1991) show the same negative payoff to risk in time periods 1926-1970 and 1970-1990.) The procedure for our study is intentionally simple, transparent and easily replicable. Our samples include non-survivors.

We look at an international universe of stocks beginning with the first month of 1990 until December 2011; we compute the volatility of total return for each company in each country over the previous 24 months. Stocks in each country are ranked by volatility and formed into deciles. In the total universe and in each individual country low risk stocks outperform, the relationship with respect to Sharpe ratios is even more impressive.

We believe this anomaly is caused primarily by agency issues, namely the compensation structures and internal stock selection processes at asset management firms which lead institutional investors on average to hold more volatile stocks. The article also addresses the implications for how corporate finance managers make capital investment decision in light of this evidence. The evidence presented here dethrones both CAPM and the Efficient Market Hypothesis.

Original paper – Download PDF

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Author

Nardin L. Baker
SSIA

Robert A. Haugen
Haugen Custom Financial Systems

Conclusion

In conclusion, this extensive global analysis spanning 33 markets from 1990 to 2011 reaffirms the persistent Low Volatility Anomaly: the consistent outperformance of low-risk stocks compared to their high-risk counterparts. Employing a transparent and replicable methodology, the study underscores that, across diverse markets, low-risk stocks consistently yield higher returns.

The compelling evidence, particularly in the context of Sharpe ratios, challenges the traditional notions embedded in CAPM and the Efficient Market Hypothesis. The anomaly is attributed, in large part, to agency issues, specifically compensation structures and internal stock selection processes in asset management firms.

As this anomaly disrupts conventional financial theories, it prompts a reevaluation of capital investment decision-making processes by corporate finance managers in light of the observed market inefficiencies.

Related Reading:

The Volatility Effect: Lower Risk Without Lower Return

The Value of Low Volatility

FAQ

1. What is the Low Volatility Anomaly, and what does the study by Nardin L. Baker and Robert A. Haugen reveal about the consistent outperformance of low-risk stocks globally?

The Low Volatility Anomaly refers to the phenomenon where low-risk stocks consistently outperform their high-risk counterparts. The study conducted by Nardin L. Baker and Robert A. Haugen spans 33 markets from 1990 to 2011 and provides extensive evidence supporting this anomaly. The research, intentionally transparent and replicable, demonstrates that, across diverse global markets, low-risk stocks consistently deliver higher returns.

2. How does the study challenge traditional financial theories such as CAPM and the Efficient Market Hypothesis?

The findings of the study challenge conventional financial theories, specifically the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis. The observed consistent outperformance of low-risk stocks contradicts the principles embedded in these traditional theories. The evidence prompts a reevaluation of our understanding of risk and return dynamics on a global scale.

3. What factors does the study attribute to the Low Volatility Anomaly, and how do compensation structures and internal stock selection processes play a role?

The study attributes the Low Volatility Anomaly, at least in part, to agency issues, particularly compensation structures and internal stock selection processes within asset management firms. The research suggests that institutional investors, influenced by these agency issues, tend to hold more volatile stocks on average. This insight into the role of agency issues contributes to our understanding of the observed anomaly and its implications for investment strategies and decision-making processes.

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