MORE RISK, MORE EXPECTED REWARD.
If you naively applied this central principle of financial theory to investing in equities over a 40-year career, youd probably want to hold a portfolio consisting mostly of high-risk stocks. Given your long time horizon, the extra volatility most likely wouldnt be a problem. You might start by buying a diversified collection of the most volatile stocks within an investable universe such as the Standard & Poors 500 Index. Once in a while, youd look at your portfolio and find that some of your stocks had low volatility or had dropped outside the investable universe, so youd replace them with newly available high-volatility stocks to stay true to your investment style. (Stock volatility here is measured on an absolute basis, not relative to a benchmark.)
To your horror, you would have significantly underperformed a cap-weighted index portfolio even within a decade. Adding insult to injury, holding the low-volatility stocks would have been better still. Whats going on here?
The historical performance of different asset classes over the long term is indeed consistent with the rule of thumb that greater risk leads to greater reward. However, it appears that this principle does not extend to individual equities. Many academic studies, as well as historical backtests of low-volatility indexes, indicate that portfolios composed purely of low-volatility stocks tend to outperform portfolios of high-volatility stocks over the long term. This phenomenon is usually interpreted to imply that low-volatility stocks have higher returns, on average. As this flies....