Less Risk, More Return

The curious tale of less-liquid stocks.

John Rekenthaler 31 December, 2015 | 10:25
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Mirror Universe
The premise of investing is that performance comes from assuming risk. No risk means no investment, as owning a riskless asset is merely saving. A little risk, a little return. More risk, more return.

That's pretty much how things happen. Consider short-term government bonds. Being only modestly vulnerable to changes in interest rates, and (for developed countries in recent years) rarely failing to meet their obligations, they are the first step up the risk ladder. Their returns have been commensurately moderate. In most major financial markets, including the U.S., short governments have been outpaced by higher-risk bonds over the long haul, which in turn have been beaten by stocks. As it should be. The same pattern should hold within the stock market. While the rule that extra return comes from extra risk was made to be broken--an individual lower-volatility stock might readily outperform its more-hazardous peers, and at various times even the overall market behaves contrarily--logic suggests that it will generally apply. If something safer consistently beats something that is more speculative, who will want to own the speculative? That security should decline in price to the point where it becomes a compelling value, so that it therefore posts suitable high future returns."

That’s pretty much how things happen. Consider short-term government bonds. Being only modestly vulnerable to changes in interest rates, and (for developed countries in recent years) rarely failing to meet their obligations, they are the first step up the risk ladder. Their returns have been commensurately moderate. In most major financial markets, including the U.S., short governments have been outpaced by higher-risk bonds over the long haul, which in turn have been beaten by stocks. As it should be.

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John Rekenthaler  is vice president of research for Morningstar.

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