Question

Historically high return stocks have exhibited lower risk than low return stocks….just the opposite what the SML (Security Market Line) predicts. Wall Street ( and unsuspecting financial planners) has been very successful in selling main street the story that higher risk = higher reward, while the smart money knows this and is able to effectively arbitrage excess returns from low risk stocks? To what extent does this make sense? Discuss and elaborate your response.

Answer 1

The current line of thought is what has been propounded by value investors like Warernt Buffett, Charlie Munger, Seth Klarman, Howard Marks etc. It is based on the idea that the risk, which is defined in wall street as the volatility is not the true measure of risk per se, hence the risk which is measured by volatility is not suffcient and hence while theoritically, developed on a mathematical base of past prices bascially says that higher risk= higher reward.

But this does not necessarily hold in market. Historically, high returns are found in stocks which are usually considered to be floating at cheap prices initially. And the only risk as defined by these value investor is paying a higher price for a stock.

Hence the risk defined in Wall street is inverted in this definiton of risk and high return stocks are only defined by price at which they are bought and hence have limited interaction with the risk in the way it is defined in Wall Street and therefore in this sense the whle argument makes sense