The virtue of boring actions in boring times.

The safest (or “boring”) stocks appear to be good investments, on average, and even more so in “boring” times. In a study published this year in the Journal of Financial Economics, a leading finance publication, co-authored by Andrew Detzel of Baylor University (USA), Paulo Maio of the Hanken School of Economics (Finland), and myself, we documented this pattern and tested several explanations. The most convincing in our tests is the existence of perverse incentives in the world of fund management. This article summarizes the study's results.

One of the most well-studied relationships in financial economics is the relationship between risk and return. On average, riskier asset classes, such as stocks, have higher returns than bonds or term deposits with lower risk. This is as it should be. However, the difference is small when comparing stocks with different risk levels. This results in the so-called low-risk anomaly, whereby investments in more "boring" stocks have returns that are too high for their risk. This pattern is a mystery with no universally accepted explanation and has been intensely studied and debated over the last 50 years.

For context, in the stock market there are companies with low risk, such as utilities (EDP, REN, for example) or companies with very stable sales (Unilever and Coca-Cola, for example). There are others with much higher risk, such as Tesla. The risk measure of the most used model (the CAPM) is beta, which measures how a company's shares respond to market fluctuations. For illustration, when the market falls 10%, Tesla falls on average 20%, therefore having a beta of 2 (=20%/10%, the ratio). REN, on the other hand, falls only 2%, as it has a beta of only 0.2.

Demanding higher returns for higher risk is to be expected. But is that what happens? Yes. In the last 60 years, in the US, high-beta stocks have had risk premiums about 30% higher than low-beta stocks (comparing extreme deciles). However, they obtain these returns with almost three times the risk (approximately 270%). This implies that a strategy that consistently invests in the "boring" stocks and bets against the "risky" ones has abnormally high returns of about 5% to 6% per year.

Several explanations have been proposed to explain the low-risk anomaly. To take advantage of it, a risk-tolerant investor would have to borrow money to invest in a leveraged portfolio of boring stocks. It is possible that not all investors with this tolerance are willing to risk the possibility of bankruptcy that this entails. (Indeed, some institutional investors are restricted in their ability to leverage their investments by their regulators, or even prohibited from doing so.) Another possible explanation rests on the idea that riskier stocks also have more upside potential. The risk-return ratio may be weak, but they have a "lottery ticket" aspect because they can have much higher returns in a fortunate scenario, even if that scenario is very unlikely. There will be investors with a preference for this type of investment.

But our study supports another explanation. This rests on the idea that professional investors are typically rewarded for beating the market in terms of returns, not in terms of risk-adjusted returns (which is how it should be). They also have an incentive to attract capital to the funds under management. An effective way to do this is to buy high-risk stocks in anticipation of a good year in the market. This is when high-risk stocks perform best and, at the same time, when investors put more capital into the funds. This creates a double incentive for institutional investors to prefer high-risk stocks, despite the low returns of those stocks for their level of risk.

In our study, we found that investing in boring stocks works best during periods of lower volatility (“boring”). This confirms the theory of distorted incentives among fund managers. In our tests, we confirmed that these managers tend to prefer high-risk stocks. They also substantially cut their positions when volatility rises to manage their risk relative to the market. On the other hand, they take on much more risk when volatility falls, selling boring stocks precisely when they acquire a more attractive profile. In other words, we observed rational behavior in these professionals, but with flawed incentives.

Our study suggests that some asset management firms should rethink their incentive systems. But this isn't obvious, as these are rational responses to the behavior of individual investors in their funds. On the other hand, investors who want to improve the efficiency of their portfolios can benefit from paying more attention to this neglected quality of boring stocks in boring times. That's when they win, just like the tortoise in the fable.