The Truth No One Tells You: Low Risk = High Reward, High Risk = Low Reward

June 6, 2017

The Truth No One Tells You: Low Risk = High Reward, High Risk = Low Reward

  • When you give fundamentals time, you really can reach high returns with low risk.
  • Look for earnings stability and earnings yield to calculate your future returns. The lower the price, the higher the earnings yield and the lower the risk.
  • If you’re happy with a 4% return in the next 30 years, the S&P 500 has almost no risk at all. If you want more, keep reading.

Introduction

Yesterday we discussed a bit how defensive investors should position themselves in today’s market. As promised, today I’ll debunk the idea that only high risk can lead to high returns.

With almost two decades of experience in stock markets, a Ph.D. in the field of stock risk, and by accepting that what they taught me in school can be wrong, I became a strong believer that low risk leads to high returns while high risk leads to low returns. The differentiating factors between my belief and what the modern portfolio theory preaches is time and fundamental analysis.

In the short term, I agree with the notion that only higher volatility can lead to higher returns. This is because the market is a voting machine in the short term and a weighing machine in the long term.


Figure 1: Markowitz’s portfolio theory. Source: Author’s design, theory by Harry Markowitz.

In the short term, the perceptions investors have about a company is what determines returns. I understand when investors get afraid or euphoric when it comes to small cap companies, but the same behavior affects even the biggest names in the industry. Wal-Mart’s (NYSE: WMT) stock went from $75 in 2014 to above $90 in January 2015, only to drop to $56 at the end of 2015 and then slowly regain territory to the current $79.49.


Figure 2: WMT’s stock surged 20% in 2015, dropped 38% in 2016, and surged 42% again. Source: Nasdaq.

However, WMT’s earnings have been relatively flat in the last 7 years and between $4.5 and $5 per share. As WMT is a huge company in a relatively stable sector, we know it can’t grow nor decline quickly and therefore, the ups and downs of the stock are irrational. However, at a stock price of $56, WMT’s price earnings (P/E) ratio was just 12.2 while at $90 it was around 20.

My point is that patient investors can buy stocks on the cheap with low risk. Buying WMT at $56 is a very low risk activity because of WMT’s strong cash flows and earnings. However, buying at $90 is highly risky because future upward movements of the stock price depend on the company meeting euphoric investors’ expectations and an earnings yield below 5%. Those who bought at $90 are still in the red while those who bought below $70 and bought more below $60 have been enjoying satisfying returns.

The fact is that in the longer term, earnings is what determines investment returns and not the irrational Mr. Market with its pessimistic and euphoric periods.

Therefore, an investor who is patient enough to wait for excellent buying opportunities in stable companies at low valuations can easily reach high long term returns with low risk.

How To Invest With Low Risk For High Returns

The cheapness of a stock gives the investor the high returns, be it through future stock price appreciation or through the high earnings yield. Investors who invested in WMT at $56 are now 42% up but even if the stock price returns to $56, their earnings yield would still be around 8%. Those who invested in WMT at $90 accepted an earnings yield of just 5%. So, high returns are achieved by buying stocks at low prices which is low risk.

The secret to low risk, high return investing isn’t to look at volatility or standard deviation as risk, focus on earnings and invest for the long term.

Volatility & Risk

The big majority of investors still see volatility as risk. This would be correct, if markets were perfectly efficient in pricing securities. However, as we have seen in the WMT example, the market is often too euphoric or too pessimistic about a stock. Many see these short-term price fluctuations as risk, but an investor should see short term price fluctuations as opportunities because lower prices allow them to buy more and consequently increase the yield their portfolio carries.

In the last 8 years, the S&P 500 has been very stable and many see it now as a low risk investment.


Figure 3: The S&P 500 in the last 8 years. Source: Yahoo Finance.

The problem is that when something bad happens, and something bad will happen sooner or later as current valuations are extremely high, the S&P 500 will drop 40% or 50% and the same people that are now describing the S&P 500 as almost riskless will spread panic and describe stocks as too risky to invest in because prices could fall more and there is no bottom in sight. However, the intelligent investor will simply look at fundamentals, use 10-year average earnings, and start buying stocks when their expected return is reached. If an investor is happy with an 8% return from stocks, they will start buying the S&P 500 below the 1,200 level as that level gives an earnings yield of 8%. An investor who wants a minimum 10% earnings yield will start buying below the 950 level.

Do these levels seem as extremely low? Well they are when compared to the current levels, but we have all witnessed even lower S&P 500 levels twice in the last 20 years. Therefore, as the current S&P 500 earnings yield is 3.88%, I can easily say that the S&P 500 is a perfect example of a low return, high risk investment. This is, of course, if you expect a higher return than 4% over the next 30 years.

How To Find Low Risk, High Return Opportunities

Many think that they have to invest as soon as they have the money because the yield on cash is almost nothing. Unfortunately, such an approach doesn’t allow them to take advantage of the many opportunities the market constantly offers.

The best way for an investor to set up a low risk, high reward strategy is to determine the investing returns he wants and then don’t invest if the investment doesn’t offer a satisfying earnings yield over a long period in time no matter what happens in the economy or stock market. Such an approach requires a bit of patience, self-control, and knowing what you want to get from your investments. But it’s certainly worth it as it lowers your risk and increases your returns.

Keep reading Investiv Daily as we’re always discussing ways to lower risk and increase returns. In the end, it isn’t so much about stock picks but about the right investing mindset.

By Sven Carlin Investing Strategy Investiv Daily Risk Share: