Interesting Article - Risk vs. Reward
Surprise! Lower risk = Higher profit
By Mark Hulbert, MarketWatch
Last Update: 12:45 AM ET May 6, 2005
ANNANDALE, Va. (MarketWatch) -- One of the central tenets of investing - one that financial planners repeat endlessly - is that risk and reward are positively correlated.
That means that in order to increase return, one must be willing to incur more risk. Conversely, in order to reduce risk, one must be willing to forfeit some return.
Try telling this to subscribers of a newsletter called fredhager.com. It is far and away the riskiest of any of the more than 180 newsletters tracked by the Hulbert Financial Digest. As measured by the volatility of its monthly returns over the last five years, it is more than six times riskier than the (SVH: news, chart, profile) Wilshire 5000 index.
The next most-risky newsletter on the HFD's monitored list is only half as risky.
And yet, over the last five years, fredhager.com is the worst performer of any newsletter the HFD monitors, having produced - according to HFD calculations - an annualized loss of 40.2 percent. Over this same period of time the Wilshire produced a 2.0 percent annualized loss.
In other words, by investing in a Wilshire 5000 index fund, subscribers to this newsletter over the last five years could have increased their annualized return by more than 38 percentage points while simultaneously eliminating the bulk of their risk.
The point of this column, however, is not to pick on fredhager.com. The newsletter's returns have not always been this poor. In fact, it was the No. 1 performer for calendar 2004 among those tracked by the HFD, for example, with a gain of 155%. And it was among the top performers for calendar 2003 with a gain of 123%.
Nonetheless, fredhager.com's track record provides a good illustration of a general phenomenon I have found from my tracking of investment newsletters: The majority of the very risky newsletters do not produce returns that are even as good as their conservative brethren - must less the significantly higher returns needed to compensate followers for the many sleepless nights.
Take a close look at the picture painted by the accompanying chart. Each of the 115 dots in the chart represents one of the newsletters the HFD has tracked over the last five years. The black line represents the trend line that most closely fits these data points. (The dot representing fredhager.com is obscured by the right most end of the trend line.)
Notice that the line is sloping downwards. This is just the opposite of how it would slope if the newsletter world adhered to the expected relationship between risk and return.
You might be inclined to dismiss this chart because it covers a period in which the market declined. But I have drawn many similar charts covering various five-year periods during the 1980s and 1990s. And in these other cases the trend lines sloped downward too.
The investment implications of the downwardly-sloping trend line are profound. It means that, regardless of your opinion of the stock market's prospects, you should follow strategies that are near the conservative end of the spectrum.
The desirability of doing so is most easily understood in the context of declining markets. In that event, needless to say, conservative strategies would be the most profitable.
But, because the majority of the most risky ones produce inferior returns even in rising markets, you should also pursue more conservative strategies even if you think the stock market will go up.
To be sure, there is no guarantee that risky strategies will be produce inferior returns.
But then again, there is no guarantee you will lose everything by betting on a single pull of the slot machine.
But is that really how you want to invest your hard-earned assets?
One more reason to do your own research?
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