A correct statement may be that there is a positive correlation between the amount of risk and the potential for returns. Generally, a lower risk investment has a lower potential for profit. A higher risk investment has a higher potential for profit, but also a potential for a greater loss.

The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.

The risk-return tradeoff is the trading principle that links high risk with high reward. The appropriate risk-return tradeoff depends on a variety of factors including an investor’s risk tolerance, time horizon of investment (long term or short term) and the potential to replace lost funds.

While conventional investment wisdom says there is a direct relationship between risk and return, it is not necessarily true always. Academic research demonstrates that low-risk stocks have historically delivered higher returns than high-risk stocks. This observation is known as the “low-volatility anomaly.”

How the Low-Volatility Anomaly Defies Conventional Wisdom:

The proposition that investors, on average, can earn higher returns by taking greater risks enjoys broad acceptance throughout the investment community. There are dangers, however, in applying risk-reward theory in practical investment decision-making. The concept of risk on which the theory is based is highly arbitrary and misleading, and does not deal with the issue of possible long-term impairment of capital values.

Empirical data indicates low-risk stocks have outperformed high-risk stocks on a risk-adjusted basis over time. Risk-adjusted return simply refers to an investment’s gain or loss relative to its risk. So, if two stocks perform the same during a given period, the one with lower risk has a better risk-adjusted return.

Simple math provides a compelling argument against a high-risk strategy. The farther an investment falls, the steeper will be its climb to break even. Low-volatility portfolios have the potential to advance in rising markets and may provide a buffer during declines.

Many studies show that stocks with higher volatility do not necessarily exhibit higher returns than stocks with lower volatility. This is perhaps one of the biggest anomalies in modern finance.

What is a low-volatility strategy?

It’s a strategy where an investor can buy and hold stocks that exhibit low long-term volatility or long-term price stability. Empirical evidence in India and other developed markets like the US have shown that investing in low volatile stocks could reduce risk at a portfolio level and increase returns for the investor. The big reason why this holds true across different geographies is primarily due to downside protection available in low volatility strategies. This means that when a market enters a bear market or a crash, low volatile stocks tend to fall less. By losing less in weak markets, the strategy needs to do less in the recovery phase to beat other strategies or benchmarks.