Optimism ruins wealth.

This warning is particularly poignant today. Since interest rates are low, investors have piled into stocks. Most either buy the bluest-chip companies regardless of their price (the good ones will only get better, right?) or start picking stocks that they don’t understand.

I won’t go into detail about how following the herd hurts: just don’t do it. A lot of “investors” from the second group, though, start with the right idea—that successful investing means being a contrarian—but they often try to out-speculate the market by buying things they don’t understand using vague or misleading analysis.

This is especially true of newbie investors who haven’t refined their BS filters yet. I feel for them. Every beginner is vulnerable.

You may have caught my recent article on why lower volatility is better than higher. Now I’ll show just how much better stable investments are in real life.

But first, a word of caution: don’t get excited. Don’t ever try to increase gains by using leverage. Don’t pawn your grandmother’s jewels, arrange a credit line, open a margin account, or take on a home equity loan to buy stocks. You will enter the nerd jungle of inscrutable math, where simply put, losses are far likelier than gains for an individual investor.

Investors who can’t or choose not to use leverage sometimes try to amp up returns by taking on too much risk through their stock picks or by trying to time the market. To their frustration, Mr. Market is a little bit of a sociopath and does not appreciate their courage.

I want everyone to calm down. This chart shows why:

If you took 100 stocks and ranked them by volatility (which tells us how erratic their price returns were during the past 36 months), you would have been three times better off investing in the bottom (more stable) 40% than in the top (wilder) 20%—and that’s been the case for the past 40 years.

Notice how performance suffers when volatility increases (moving from left to right along the horizontal axis). Higher risk doesn’t necessarily mean a higher return.

This low-volatility trend—continuous outperformance by the steady-Eddie stocks—has persisted for nine decades now, and there are solid reasons why it will continue. BMO Global Asset Management published a very good (but highly technical) summary of why the low-volatility trend is here to stay. I’ve outlined the major reasons below.

  • Investment managers have an incentive to purchase riskier stocks. Their compensation structures are often set up so that they gain if their stock picks outperform but don’t lose if their portfolios tank. This “heads I gain, tails you lose” situation makes them prone to investing in iffier stocks.
  • Investment managers are punished for tracking errors, which means that their portfolios need to track the corresponding benchmark indices very closely. Going off-track is a no-no. Thus, they have a disincentive to purchase stocks that would lead their portfolios away from various market indices too much, which in turn makes it harder to buy stocks with low-volatility returns.
  • Hedge funds and other institutions that can arbitrage away or exploit this “low volatility-high returns” market anomaly into nonexistence by using leverage aren’t very interested in it. BMO gives these numbers: The global capital market has about $200 trillion in investable assets, and hedge funds have about $6 trillion. While $6 trillion is a large sum of money in absolute numbers, it’s small compared to the whole capital market, and a lot of this $6 trillion is invested in fixed-income vehicles anyway, away from the equity market.
  • As we saw with “too big to fail” banks, investment managers are prone to taking large risks when investing other people’s money in hope of getting a nice commission or share of their success.
  • This final point is speculative, I’ll admit. The market is obsessed with short-term profits and doesn’t care about eventually. It’s like giving an alcoholic a choice: have a glass of scotch every day or become the owner, for free, of a fine distillery from which he can take 100% of the profit and enjoy the product——but only after he retires. It’s obvious why he wouldn’t choose Option 2. A glass a day is real; the future is murky.

Another major reason why the low-volatility anomaly isn’t going away is a basic human failing: greed. As long as humans continue to be greedy and irrational, some investments will be overpriced and others overlooked.

I keep pounding the table saying that stability is important in order to reinforce a simple point: today’s market is too excited. While I don’t think we’re experiencing a mania that will end soon in a dramatic crash, it becomes harder and harder to keep a cool head as the S&P 500 keeps reaching new highs. But remember, every carnival ends.