by: Lawrence Hamtil
One of the more fascinating theories in behavioral finance is the "theory of leverage aversion," which, simply put, is the notion that investors who cannot or do not wish to add leverage to their portfolios (in order to magnify returns) instead do the next best thing, which is to load up on stocks with high beta. In rough terms, a high beta stock is one with higher-than-average volatility than the overall stock market, but also therefore a higher chance of outperforming the market by delivering outsized returns, something researchers have come to call "lottery stocks."
We can see from the last few decades of returns that high beta stocks (as defined by the S&P 500 High Beta index) have tended to produce these lottery-type outcomes, with strong outperformance in many up years, but also with steep underperformance in several years:
Another way to view the effect of high beta is with a distribution of annual returns. Over the last twenty-seven years, the high-beta portfolio has generated the widest dispersion of outcomes, with a couple of extreme outlier years in both up and down markets. Conversely, both the overall market and high-beta's counterpart, low-volatility, have produced a far narrower range of outcomes:
Generations of investors have been told that risk and reward go hand-in-hand, so given the extreme volatility of high beta's performance one would think that investors have been compensated for this risk. In years in which the markets were positive, high beta investors generally were compensated for this higher risk, capturing, on average, 138% of the market's return. However, in down years for the market, high beta investors got clobbered, suffering declines that were, on average, roughly 243% of the market's decline. As a result, the riskier portfolio actually underperformed the market as well as, paradoxically, the low-volatility portfolio:
A very good explanation for this paradox of higher risk and lower returns from high beta stocks comes from Cliff Asness of AQR, who wrote a detailed paper on the subject. In simple terms, Cliff and his team found that leverage constraints cause investors to bid up the prices of these lottery-type stocks, ballooning their valuations, and reducing their prospective returns.
In sum, investors who find themselves behind on savings goals might be tempted by the allure of high beta stocks, hoping to make up for lost time by betting on magnified outcomes. However, experience has shown that this is unwise, often leaving investors worse off than they might otherwise be.
The information provided above is obtained from publicly available sources and it is believed to be reliable. However, no representation or warranty is made as to its accuracy or completeness.
Lawrence Hamtil is a fourteen-year veteran of the financial services industry, having served clients in all aspects of the business during his career, which started in 2002. In 2005, he joined Dennis Wallace of Fortune Financial Services, LLC, becoming, at the time, one of Multi-Financial Securities, Inc's youngest registered representatives. In 2008, Dennis and Lawrence made the decision to become fully independent by founding their own Registered Investment Advisory (RIA), Fortune Financial Advisors, LLC. He serves clients in the United States and Europe. His financial commentary has been referenced in Barron’s online edition.
You can connect with Lawrence on Twitter ( @lhamtil) or via email, firstname.lastname@example.org.