Practical analysis for investment professionals
12 November 2013

Rewrite the Finance Textbook: Low Risk Offers High Return

As investment professionals, we were taught wrong. We were taught capital asset pricing model (CAPM) and efficient market hypothesis (EMH), which are overly simplistic. And contrary to what we were taught, low-volatility stock portfolios consistently outperform. This was the bold assertion made by Nardin Baker, CFA, chief investment strategist at Guggenheim Partners, who spoke to a hall full of investment professionals at the CFA UK Annual Conference 2013.

Referring to “Low Risk Stocks Outperform within All Observable Markets of the World,” a research paper he coauthored with Robert A. Haugen, Baker added that not only do these low-volatility stock portfolios outperform, but they also outperform in all equity markets of the world across time. Baker and Haugen’s study extends from 1990 to 2011 and covers stocks in 21 developed markets and 12 emerging markets.

To critics who may be eager to point out the usual problems with the research methodology, such as survivorship bias, nonrepresentative samples, and replication issues, the paper offers an early clarification: “Our procedure is intentionally simple, transparent and easily replicable. Our samples include non-survivors. Our database includes 99.5% of the capitalization in each country.”

The methodology used by Baker and Haugen is indeed simple to understand. They ranked the stocks in terms of volatility as measured by standard deviation and compared the returns for each month. As their paper says, “Beginning with the first month of 1990, 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, quintiles, and halves. We then observe the total return for each decile in the first month of January. Next we re-rank stocks and observe the returns for February. Finally, we continue the process for each of the 264 months of the total period.”

Baker went on to claim that these low-volatility stocks don’t just outperform, they outperform by a wide margin, which becomes even wider when risk-adjusted returns are used. Terming it “the biggest market inefficiency” and “a huge opportunity,” Baker said that he has never seen any other strategy that is able to consistently perform at such a high level of return.

But why does “the biggest market efficiency” persist? Baker offered explanations relating to the principal–agent problem and behavioral biases:

  • Investment managers are the agents of investors, and for a manager paid a base salary and a performance bonus, the expected value of compensation is higher with a more volatile portfolio.
  • Security analysts have to compete within their firms and make a compelling case for the stocks they cover, so they opt for noteworthy stocks about which there is greater information flow, which happen to be high-volatility stocks.
  • There are too few short positions in the market. Less than 2% of the value of the S&P 500 is held short. The high-volatility stocks are not being pounded down the way they should be.
  • There is competition for higher return for capital. A high-growth company with a volatile stock could grow earnings at 25% but may only be able to grow earnings at 20% as other companies jump in. Unlike the growth of more volatile companies, those growing slower have lower volatility and less competition.

Baker said that investment strategies based on low-volatility stocks are not new; the first portfolio was created in 1988. According to Baker, low-volatility investment strategies did not take off back then because they were antithetical to financial theory, there was not enough competition among investment managers, and the market was rising. Investors were not sufficiently interested in low volatility. Baker thinks that as more and more investors buy low-volatility stocks, eventually their prices will rise and the prices of high-volatility stocks will fall. But at present, we are at the beginning of that process, and he is observing more inflows in low-volatility strategies than before.

Baker has faith in the outperformance of low-volatility stocks, even if it directly conflicts with what is suggested by CAPM and market efficiency. If something should give way, Baker thinks it should be the finance textbook. “There is no model that explains the real world,” he said.

The same sentiment is expressed in the conclusion of the paper: “It is now clear to a greater and greater number of researchers and practitioners that inside all of the stock (and even some bond) markets of the world, the reward for bearing risk is negative. Greater risk, greater reward is a basic tenant of finance; thus its invalidation carries critical implications for the theories underlying investment and corporate finance. In our view, existing textbooks on both subjects are dramatically wrong and need to be rewritten.”

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
Usman Hayat, CFA

Usman Hayat, CFA, writes about sustainable, responsible, and impact investing and Islamic finance. He is the lead author of "Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals;" the literature review, "Islamic Finance: Ethics, Concepts, Practice;" and the research report "Sustainable, Responsible, and Impact Investing and Islamic Finance: Similarities and Differences." He is interested in online learning and has directed three e-courses for CFA Institute: "ESG-100," "Islamic Finance Quiz," and "Residual Income Equity Valuation." The other topics he writes about are macroeconomics and behavioral finance. He has experience working in securities regulation and as an independent consultant. His qualifications include the CFA charter, the FRM designation, an MBA, and an MA in development economics. He has served as a content director at CFA Institute. He is a former executive director at the Securities and Exchange Commission of Pakistan (SECP) and former CEO of the Audit Oversight Board (Pakistan). His personal interests include reading and hiking.

18 thoughts on “Rewrite the Finance Textbook: Low Risk Offers High Return”

  1. Brian Haskin says:

    Usman, great write up – thank you! Wish I could have been there. What is amazing is how long some of the research that supports the low volatility effect has been in the financial and academic community. The late Bob Haugen’s website ( lists out a vast amount of the research (look under Resources / Low Vol Research), covering the various methods to building low volatility portfolios.

    Thanks again for the article.

    1. Brian Haskin

      Thank you for your kind comment. Yes, it does seem that the low-volatility ideas have been around for a while.

  2. Antonio says:

    Usman – nice article.

    I would however add the following: The authors fail to address the asymmetrical nature of volatility (i.e. semi-variances) and the higher moments of the return distribution. It would have been nice to see some statistics regarding skewness and kurtosis. Volatility, when viewed in isolation, can greatly distort reality. If we also include a time-varying approach and better capture the non-linear nature of risk, it hopefully becomes more apparent that the authors’ simplistic approach becomes just as questionable as those based on Modern Portfolio Theory.

    Thank for sharing this information.

    1. Antonio,

      Thanks for your comment. Yes, it would be interesting to know whether or not alternative measures of risk lead to the same conclusion about low volatility portfolios.

  3. Pito Hui says:

    I wouldn’t disagree that low risk investments do offer good return, but I do not see how the research study account for active monitoring of a short-term high risk portfolio. The study only compare monthly returns, which ignored well targeted short-term trading can earn extra ordinary returns in as few as 3 days (T+3 margin trading). This effect would have been totally left out as the share price might have returned to its normal levels by the end of the month.

    1. Pito Hui,

      Thanks for visiting the Enterprising Investor blog.

      With so much literature pointing out lack of alpha in active investing, I wonder if one can consistently beat the market based on short term trading.

  4. Umed Saidov says:

    Very insightful article indeed. Put another way: investors cannot get higher returns by assuming higher risk as measured by volatility. Market players seem to be biased and “mis-price” the risk. Now I wonder which capitalization category was most prevalent in Baker’s low-volatility stocks… I would not be surprised if most were mid to small cap stocks with little or no coverage.

    1. Umed Saidov

      Thanks for reading this blog post.

      The paper does say that “Our database includes 99.5% of the capitalization in each country.”

  5. Brad Case says:

    Thanks, Usman. The empirical results provided by Baker & Haugen are interesting; unfortunately the paper itself is very strange and detracts considerably from the empirics. (For example, the paper puts a great deal of weight on a conspiracy theory regarding the academic research process; it also misrepresents the Fama & French research egregiously and unnecessarily.)

    There are much better discussions of the “low volatility anomaly” or “volatility puzzle.” One good example is by Lionel Martellini of EDHEC Business School (, and another is by Aye Soe of Standard & Poor’s (

    Investors and investment managers should know that the low volatility anomaly doesn’t necessarily apply over investment horizons longer than one month, which is what Baker & Haugen used. Take a look at the paper by Huang, Liu, Rhee & Zhang published in Journal of Investment Management (2011) and available at

    1. Brad Case

      Thanks for reading the blog and pointing out other research on the issue, much appreciated.

  6. Haripreet Batra says:

    This supports Buffet’s investing model that he likes to invests in industries with low rate of change in the underlying business. But must agree with Umed that this seems to be distorted by mid to small cap stocks contribution (given he covers 99.5% of the market cap) some of which may be volatile with no long term future/returns.

    1. Haripreet Batra

      Thanks for sharing your views. I looked at the research paper by Baker and Haugen again and I did not find a discussion on the proportion of low to mid cap stocks in the low volatility portfolio. Perhaps, it is an issue best addressed by the authors.

      1. Brad says:

        I noticed that too, and truthfully I think they did’nt do the research as carefully as they would have to in order to get it published in a peer-reviewed journal. But others have researched the same issue much more carefully, and the Baker & Haugen results are not out of line.

  7. Hi Usman,

    Would like to thank you for this timely article. In fact, we have a project on “Redefining Risk” where we are reexamining the risk-return paradigms.

    In case you are interested in our article, recently presented at the Association of Behavioral Finance and Economics Conference in Chicago:

    Redefining Risk: Propositions to Motivate a Re-Examination of the Standard Risk vs. Return Relationship in Common Stock and Bond Portfolio Management

    1. Mohammad Siddiquee

      Thank you for visiting Enterprising Investor blog and sharing your research paper. I will take a look at it, I’ve added it to my list of things to read.

  8. Bryan Baggenstos says:

    As far as the comment about CAPM. I think Baker, like most of the industry, has misquoted it. CAPM says that a rational investor should ***require*** a higher return to take on more risk (or volatility). That is very different from saying they will ***receive*** a higher return. Many investors have interpreted CAPM this way. It has very educated investors buying risky assets to increase expected returns, which has the expected returns of those assets dropping, which leads to less risky assets outperforming (especially on a risk adjusted basis).

    I hear, way to often, very experienced and educated people saying that expected returns are too low so we need to take on more risk to achieve our return expectations. In my opinion that is exactly the opposite of what we should do when expected returns are too low and I think Bakers research validates my approach. When expected returns are high it may be a different conversation, and taking on additional risk may be worthwhile (at least it has been in my portfolio).

    In short, we often look at the return we want (or need) and take the lowest amount of risk needed to achieve our goals. Alternatively we should be looking at the payoff for taking risk and deciding whether or not we are receiving adequate compensation. Until we change our point of reference, lower volatility securities will continue to outperform.

    1. Bryan Baggenstos

      Would it be a ‘rational expectation’ to expect high risk from high return if it turns out that it is low risk that consistently provides high return, as argued by Baker?

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