A popular prejudice in investing is that a higher risk is also connected with higher yields.
According to experience, however, this statement has turned out to be too simplistic. It has actually been established that this relation between risk and return is only valid in the area of low and moderate risks. However, in the area of high risks it appears that the yields diminish as risks rise.
On the basis of this perception, two styles of investment in shares have developed:
- Minimizing operating risk: focusing on investing in the shares of companies from sectors with relatively stable earnings. In general these are sectors with a low dependency on the business cycle such as food producers, household goods or medical equipment makers. This strategy strongly resembles the results that are produced by the approach of looking for growth shares with stable earnings increases.
- Minimizing mathematical risk: optimisation models are used that prefer shares with a low variance and, therefore, with a low price risk. However, a purely quantitative approach can be problematic because the liquidity risk is often insufficiently considered. Furthermore, the price risk is not always a sufficient indication of the default risk.
Both approaches are not as popular as one might think with regard to their performance qualities for the longer term. The reason for this might be that they prove their superiority compared with conventional index investments mainly in difficult market phases, when price developments are dominated by economic and political uncertainties. In periods of rising stock markets, however, they are inclined to lag behind the market, because investors get more optimistic and rush to buy the "market laggards". These are qualitatively less good shares, which have underperformed before.
Because investment managers are mainly judged on their short-term performance, they are often afraid to take on the risk of a significant divergence from a market index. Those who fall behind in a rising stock market are often punished relatively fast by consultants and clients, even if their strategy proves to be right in the longer term.