Does Higher Risk Really Lead To Higher Returns?

Posted: Dec 16, 2011

David Allison

Contact | Author Bio

ARTICLE HIGHLIGHTS

• Studies have suggested that high risk stocks don't always have higher returns.
• As a whole, investors misjudge their ability to assess when stocks will "pop."
• The low-volatility anomaly probably exists because it is not easy to exploit.

Many widely accepted financial models are built around the premise that investors should expect higher returns if they are willing to accept more risk. However, will investing in a portfolio of risky stocks really help increase your investment returns over time? The answer may surprise you. Read on to learn about what is being dubbed the "low-volatility anomaly," why it exists, and what we can learn from it.

TUTORIAL: Risk And Diversification

The Low Down on Low-Volatility Stocks
If the modern portfolio theory holds true, a portfolio of risky, highly-volatile stocks should have higher returns than a portfolio of safer, less-volatile stocks. 

However, stock market researchers are discovering that this may not always be the case. A March 2010 study by Malcolm Baker, Brendan Bradley and Jeffrey Wurgler, published in the Jan./Feb. 2011 Financial Analysts Journal and entitled, "Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly," demonstrated that from Jan. 1968 to Dec. 2008 portfolios of low-risk stocks actually outperformed portfolios of high-risk stocks by a whopping margin.The study sorted the largest 1,000 U.S. stocks monthly into five different groups, based on two widely accepted measures of investment risk. The authors ran the study once, using trailing total volatility as a proxy for risk, and again using trailing beta. 

Over the 41-year period, a dollar invested in the lowest-volatility portfolio of stocks grew to $53.81, while a dollar invested in the highest-volatility portfolio grew to only $7.35. The findings were similar when they grouped stocks based on trailing beta. Over the same period, a dollar invested in the lowest-beta portfolio of stocks grew to $78.66, whereas a dollar invested in the highest-beta portfolio grew to a paltry $4.70. The study assumed no transaction costs.

These results fly in the face of the notion that risk (volatility) and investment returns are always joined at the hip. Over the study period, a low-risk stock investor would have benefited from a more consistent compounding scenario with less exposure to the markets most overvalued stocks. (For a related reading on how volatility affects your portfolio, check out Volatility's Impact On Market Returns.)

Fast Money?
Proponents of behavioral finance have presented the idea that low-risk stocks are a bargain over time, because investors irrationally shun them, preferring stocks with a more volatile, "lottery style" payoff. Backers of this school of thought also believe that investors have a tendency to identify great "stories" with great stocks. Not surprisingly, these highly touted "story stocks" tend to be among the markets most expensive and most volatile. Overconfidence plays a role here, too. As a whole, investors misjudge their ability to assess when stocks will "pop or drop," making highly volatile stocks appear like a better proposition than they really are. Even the so called "smart money" has a tendency to gravitate towards risky stocks.

Many institutional investors are compensated based on short-term investment performance and their ability to attract new investors. This gives them an incentive to pass up less volatile stocks for riskier ones, especially in the midst of a raging bull market. Whether it is bad habits or disincentives, investors have a tendency to pile into the market's riskiest stocks, which drive down their potential for future gains, relative to less volatile ones. Consequently, low-risk stocks tend to outperform over time.

Before You Bet the Farm on Low-Volatility!
Before you trade all of your technology stocks in for a portfolio of utilities, keep in mind that, like most stock market anomalies, this one probably exists because it is not easy to exploit. A study published in Sept. 2011 by Rodney Sullivan and Xi Li entitled, "The Limits to Arbitrage Revisited: The Low-Risk Anomaly," explored the viability of actually trading the low-volatility stock anomaly from 1962 to 2008. Over the 45-year study period, Sullivan and Li found that, "the efficacy of trading the well-known low-volatility stock anomaly is quite limited." Issues cited in the study include the need for frequent portfolio rebalancing and the high transaction cost associated with trading illiquid stocks. According to the study, illiquid stocks are where most of the abnormal returns associated with the low-volatility anomaly are concentrated.

There are a few other issues associated with investing in low-volatility stocks. Low-volatility stock investing strategies can suffer long periods of under-performance relative to the broader stock market. They also have a tendency to be heavily concentrated in a few sectors like utilities and consumer staples. (Among the methods used to measure volatility, specifically in technical analysis, is calculating average true range. Read more at Measure Volatility With Average True Range.)

The Bottom Line

The positive relationship between risk and expected returns may hold true when investing across different asset classes, but the same may not always be true when investing within a particular asset class, like stocks. While it is dangerous to assume that you can boost your investment returns simply by investing in a portfolio to risky stocks, it can be equally as dangerous to assume that researchers of the low-volatility stock anomaly have somehow discovered a silver bullet to achieving higher returns.

Stock investors shouldn't overlook the importance of consistency when attempting to compound their investment returns. They should also take into account that the stability of a company's stock price is often a reflection of the true quality of its underlying earnings stream.

by David Allison

David L. Allison is vice president and the founding partner at Allison Investment Management LLC, an investment advisory firm offering managed accounts to high-net-worth investors and institutions. He received a bachelor's degree from the University of North Carolina at Wilmington where he majored in finance. He currently holds the Series 7 and Series 66. David has earned both the Chartered Financial Analysts (CFA) and the Certificate in Investment Performance Measurement (CIPM) designations. He is an advisor to CFA Institute serving on the CIPM Examination Review Panel. He is a member of the CFA Institute, the CIPM Association, the North Carolina Society of Financial Analysts (NCSFA), and the CFA Society of South Carolina, where he is a past President and currently serves on the Board of Directors. In addition, he is First Chair on the Coastal Carolina University Wall College of Business Finance Advisory Board. Securities are offered though Triad Advisors, Inc. Member FINRA & SIPC.

Read more: http://www.investopedia.com/articles/trading/11/higher-risk-higher-returns.asp#ixzz1he51xVDN

Basic Investment Objectives

The options for investing our savings are continually increasing, yet every single investment vehicle can be easily categorized according to three fundamental characteristics - safety, income and growth - which also correspond to types of investor objectives. While it is possible for an investor to have more than one of these objectives, the success of one must come at the expense of others.


Primary Objectives
Safety
Income
Growth of Capital

Secondary Objectives 
Tax Minimization
Marketability/Liquidity



Read more here: 
http://www.investopedia.com/articles/basics/04/032604.asp#ixzz1hd8cdsGt

7 Courses Finance Students Should Take

Posted on Oct 24, 2011 by Brigitte Yuille

Most careers in finance involve finding effective ways to manage an organization's money, in order to create wealth and increase the organization's value. Finance majors prepare for this career by studying topics about "planning, raising funds, making wise investments and controlling costs," according to the College Board. This knowledge sets them up for a wide array of career paths in the areas ofcorporate finance, financial institutions and investments.

Tutorial: Education Savings Account

Executives in search of well-rounded finance students look for certain skills. Studies have revealed that these executives want schools to place more emphasis on quantitative, strategic, critical decision-making and communicative skills, which are sometimes best developed in classes outside of business schools. If you want to get the best possible preparation for the finance world from your undergraduate education, put some thought into which classes to take, that may fall outside the finance curriculum.

What Companies Want
Business leaders at Booz Allen Hamilton, a strategy and technology consulting firm, discussed areas of change that could be implemented at graduate business schools, in the article "What Business Needs from Business Schools." They suggested that more courses were needed to teach graduates to effectively manage individuals and team-driven organizations, provide tools for problem solving and provide better grounding in theory. They also recommended more courses outside of the traditional curriculum. (Companies are in need of strategic candidates, not walking resumes. Learn more in Business Grads, Land Your Dream Job.)

Finance professors at Duke and Berkeley have made suggestions for courses finance students should take, outside of their business school curricula. John Graham, a finance professor at Duke University's Fuqua School of Business and John O'Brien, finance professor at Berkley's Haas School of Business, recommend the following areas of study:

• Mathematics - Courses in college algebra and calculus will help students learn how to solve equations in complex financial markets. Statistics helps with decisions based on the likelihood of various outcomes and allows finance students to learn to reach conclusions about general differences between groups and large batches of information. It also explains the movements of a company's stock.
  
• Accounting - Financial and managerial accounting courses teach finance students how to understand, record and report financial transactions, monitor the company's budgets and performance, and examine the costs of the organization's products and services.
  
• Economics - Economics looks at how scarce resources are allocated to achieve needs and wants. A course in macroeconomics will teach finance students to understand the impact of financial market activities on the overall economy. Microeconomics will help them understand the behaviors that occur within individual firms and among consumers, as well as how various financial decisions can impact a firm's success. (For more on these subjects, read Economics Basics: What Is Economics?, Macroeconomic Analysisand Understanding Microeconomics.)
  
• Psychology - Financial professionals need to understand the behaviors and thought processes that help drive the movements in financial markets. A course in critical thinking teaches a finance student to reflect and evaluate an argument, and examine situations in all dimensions before applying a solution. This involves understanding what is not known about the situation versus what is known. Behavioral finance can help finance students explore why and how the financial markets aren't working, by examining how investors' behaviors are associated with market anomalies. This subject helps financial professionals determine where investors make mistakes and how to correct them, by examining the emotion or thought behind the actions. Behavioral psychology helps finance majors look at the observable and cognitive aspects of human behavior, within a financial environment. (Find useful insight about how emotions and biases affect the market in Taking A Chance On Behavioral Finance.)
  
• Writing - A course in technical writing will teach students how to put forth strong, clear and organized ideas, purposes and explanations in memos, reports and letters.

Additional Course Recommendations

The business consultants at Booz Allen Hamilton, Joyce Doria, Horacio Rozanski and Ed Cohen, made their case for curriculum reform and also recommended courses in psychology, economics and human behavior. In addition, they recommended classes in the following areas of study:

• Communications - A communications course, such as public speaking, helps finance students present financial reports and explain the meanings behind equations and numbers, to colleagues in group settings. It also helps with the management of people and organizational relations, such as in delegating responsibilities to employees within financial departments. Business students also need courses in corporate communications, crisis communications and PR strategies, according to a 2005 Public Relations Society of America study. It states how financial scandals and downturns can affect shareholder support, consumer confidence and corporate reputation issues. Finance students will benefit from knowing how to handle corporate reputation issues, should they arise.
  
• Ethics - Corporate scandals, such as the Enron scandal, which involved irregular accounting procedures, have also encouraged some business schools, such as the University of San Francisco and Loyola University Chicago, to add a course in ethics to their finance curricula. These courses focus on moral development in an attempt to stem future misconduct in business environments.

The Bottom Line 

Students studying finance will be tasked with big responsibilities in their careers. They will have to manage the flow of money at their companies and identify financial risks and returns to make effective business decisions. Those finance majors who want to have an edge over their competition, both during the initial post-graduate job search and throughout their careers, will take advanced mathematics, accounting, economics, psychology, communications and writing courses to gain a deeper insight into their jobs and a better ability to work effectively with people. 

For related reading, see Top Job-Search Mistakes For Finance Grads, How To Land A Finance Job Straight Out Of Undergrad and Top 10 Cities For A Career In Finance. 

Author: Brigitte Yuille
http://www.investopedia.com/articles/professionaleducation/09/non-finance-courses.asp?mobileapp=1

Uncovering Oil And Gas Futures

Posted: Apr 28, 2011

James Vitalone

Contact | Author Bio

ARTICLE HIGHLIGHTS

• New information regularly disseminated to the market induces price volatility.
• Weekly oil and natural gas supply data is published by the EIA.

Prices for crude oil, crude oil products and natural gas futures constantly change in response to new information and reflect the adjustments being made to previous and prospective expectations. The relative size and duration of those adjustments often depend on the nature of the new information and the way it is received. Unanticipated new information quite often induces extreme price volatility creating a price shock. For example, the 1973 oil embargoby OPEC members caused oil prices to spike to historical highs.

TUTORIAL: Futures Trading 101

New information regularly disseminated to the market also induces price volatility, which can range from barely noticeable to extreme because even though the information is anticipated, its content may not be in line with the market's expectations. This is particularly true of the data periodically released on oil, petroleum products and natural gas inventories. Here we'll cover where the information for this industry comes from and when to expect it. (For background reading, see Oil And Gas Industry Primer.)      

Where the Data Comes from
Weekly oil and natural gas supply data is published by the Energy Information Administration (EIA), an independent agency of the United States Department of Energy. In fulfilling its responsibility as policy advisor to the Department of Energy, the EIA's job is to objectively collect, interpret and analyze all energy-related data.

The EIA schedules the weekly publication of data highlighting U.S. crude oil and petroleum products inventory levels each Wednesday through two separate reports. The first, called the Weekly Petroleum Status Report is distributed mid-morning and features raw inventory data along with recent commodity and product spot and futures prices. The second report, This Week In Petroleum, is available later in the afternoon. In addition to more extensive data points, this report includes commentary by the EIA about the most recent data.(To learn more about futures, see Futures Fundamentals and Fueling Futures In The Energy Market.)

The EIA makes its report on U.S. natural gas storage levels available each Thursday. Similar to its oil reports, it also releases two separate reports; the Weekly Natural Gas Storage Report is released mid-morning in the form of a much smaller "flash" report. It's similar to its crude oil counterpart in that only the raw storage data is included. Additional data points and the EIA's detailed analysis of the morning data is published in the Natural Gas Weekly Update in the afternoon.

These reports are available at no cost and can be received by email automatically each week once you sign up at the EIA's website.     

Like the Energy Information Administration, the International Energy Agency (IEA) serves as the energy policy advisor to the 26 countries comprising the Organization of Economic and Cooperative Development (OECD). Also like the EIA, it collects, interprets and analyzes data related to energy. However, unlike its U.S. counterpart, the IEA's data relates to global crude oil supply and is released with the publication of the monthly Oil Market Report. Data presented each month is given a detailed analysis and provides a perspective for the IEA's updated crude oil price outlook, which is also included in the report. A paid subscription is required to receive the current report when published.

Crude Oil Inventories 
Crude oil is the primary refinery input; therefore, any changes in the level of crude oil inventories from one reporting period to another not only impact the price of their underlying futures contracts, but will also affect the price of underlying futures contracts of associated refined products like gasoline. The petroleum inventory data showing the level of U.S. crude oil inventories first highlights the portion of current inventory produced within the U.S. then it highlights additional data indicating the portion of total crude oil inventory that was imported. (Fore more, check out Understanding Oil Industry Terminology.)


More specifically, U.S. petroleum product inventory data pertains to the level of refined products, such as motor gasoline, jet fuel, distillate fuel oil (source of diesel fuel) and residual fuel oil that are readily available. Like crude oil inventories, petroleum product inventories data also identifies the portion that is the result of imports. In addition to the impact on refined product futures prices caused by both changes in crude oil and refined product inventories, volatility in refined product futures prices can also be attributed to changes in the portion of total inventories that has been imported. Underlying contract price volatility is likely to increase upon evidence suggesting that the proportion of imported refined product to total inventories is increasing.

Natural Gas Data 
Published natural gas inventory, or "storage," refers to the network of more than 400 locations throughout the contiguous 48 states. It is designed to highlight the volume of natural gas that can be readily delivered to natural gas consumers, principally in the U.S. This includes power generation plants, industrial and commercial users, and households. Like crude oil and petroleum product inventories, natural gas storage data provides a look at absolute levels as of the reporting date as well as changes to those levels from prior periods. However, unlike crude oil and petroleum product inventories, owing to characteristics that largely prevent it from being transported over particularly long distances, storage level data represents natural gas coming only from U.S. production efforts. (Learn more in Natural Gas Industry: An Investment Guide.)

The Effect on Oil and Natural Gas Futures Prices             
Information concerning crude oil and natural gas supply levels will affect the price of underlying futures contracts as the market undergoes a process of reconciling and adjusting past expectations, as well as readying new ones based on the most recently reported data. Moreover, the extent to which some or all of the actual data departs from expectations is manifested by the degree of resulting price volatility. For example, energy future prices tend to rise following an inventory report that indicates that gasoline inventories remained unchanged, whereas analyst prediction may have expected that inventory to rise.

For related reading, see Price Volatility Vs. Leverage. 

by James Vitalone, CFA

James W. Vitalone, CFA, is an oil and gas investment banker with Oberon Securities in New York. He has more than 25 years of experience in the investment services industry. Previously, Vitalone was a buy- and sell-side securities analyst for 15 years, covering companies in the oil and gas, drilling, and oil service and natural gas industries. Prior to that, he was a portfolio manager working with institutional and high net worth clients.

Vitalone has a Bachelor of Business Administration in finance, an MBA in accounting, a Juris Doctorate degree and has served as chairman of the CFA Institute's U.S. Advocacy Committee.

Read more: http://www.investopedia.com/articles/optioninvestor/07/oil_gas.asp#ixzz1hcnuA9Id