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Why you shouldn't believe that investing in high-risk stocks will make you more money

by , 05 June 2015

There's a common belief in investing that the higher the risks you take on, the greater the potential reward may be.

Long-term performance of stocks and bonds provides evidence to back this up. Historically, stocks have outperformed bonds. This implies greater reward for investors taking on the higher risks of investing in stocks over bonds.

But it may not be as clear cut as this. When it comes to investing in stocks, investors may be better off investing in lower risk stocks.

Read on to find out more and how your investment performance could benefit…

High risk doesn’t always mean high reward

Research has shown that shares with less volatile prices tend to outperform shares with more volatile share price.

Of course, this doesn’t apply to every stock, but on average, low-risk shares have beaten high-risk ones, Piper Terrett in Money Week explains.

Robert Haugen and James Heins spotted this back in the early 1970s. They found there was a negative relationship between risk and return in the US stock market and the bond market.

Haugen and Heins concluded the higher the risk, the lower the realised return.

Numerous other studies since then have come up with the same conclusion.

Why investing in low-risk shares can be more profitable

Feifei Li of US research firm, Research Affiliates, says it has a lot to do with low-risk stocks trading at a discount to the wider market and to higher risk shares for long periods of time.

The reasons behind this may lie with behaviour rather than financial factors. For example…

Investors are more likely to invest in high-risk stocks as there’s a chance of better returns, ignoring lower-risk stocks in the process. This pushes up the prices of these higher-risk stocks, and pushes down the prices of lower-risk stocks.

More volatile stocks hit the headlines. This creates a demand for these shares.

Even the behaviour of fund managers could have an impact on this. Fund managers tend to focus on high performing stocks, ignoring lower-risk stocks in the process.

What this means for you as an investor

If history is anything to go by, focusing on buying low-risk stocks and holding for the long-term pays off. Of course, if everyone in the market started doing this, the prices of lower-risk stocks would rise.

But with long-term performance on their side for the moment, an investment strategy focusing on low risk, low volatility stocks could prove profitable.

So there you have it. Why you shouldn’t believe that investing in higher risk stocks will make you more money.

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Why you shouldn't believe that investing in high-risk stocks will make you more money
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