Buying Canada right now, particularly income trusts and high-dividend-paying corporations, means accessing a relatively stable, low-beta play on a global economic recovery.

— Roger Conrad, Canadian Edge

With the Dow Jones Industrial Average (DJI: ^DJI) down 3.5% today in a continuing investor revulsion toward the “Operation Twist” monetary policy action taken by the Federal Reserve yesterday, stock market volatility continues to amaze. Some market pundits have reportedly recommended that investors buy high-beta stocks as a way to recoup losses quickly.

Beta is a measure of a stock’s relative price volatility compared to the general stock market. A stock with a beta of 1.0 has the same price volatility as the S&P 500 index. High-beta stocks have betas above 1.0 and move by a larger percentage than the S&P 500 moves, both during S&P up moves and down moves. The rationale given for recommending the purchase of high-beta stocks is that the only way to get a higher return is to take higher risks (i.e., higher volatility).

Don’t believe it!

Forget the CAPM: Higher Rates of Return Do Not Require Higher Risk

In Buy Small-Cap Stocks Before They Grow Up and The Growth vs. Value Debate, I discussed how the traditional capital asset pricing model (CAPM) predicted a stock’s future returns based solely on its beta – the higher the beta, the higher the expected return. I then explained how University of Chicago finance professor Eugene Fama and Dartmouth College finance professor Kenneth French had improved on the original CAPM by creating a three-factor model based on two additional risk factors besides beta: (1) smallness and (2) cheapness.

But a new 2011 study headed by Harvard University finance professor Malcolm Baker has turned finance theory on its head. Based on a 40-year study of stock returns between 1968 and 2008:

Low-volatility and low-beta portfolios offered an enviable combination of high average returns and small drawdowns. This outcome runs counter to the fundamental principle that risk is compensated with higher expected return.

We believe that the long-term outperformance of low-risk portfolios is perhaps the greatest anomaly in finance. Large in magnitude, it challenges the basic notion of a risk-return trade-off.

Professor Baker calls investing in low-beta stocks “the best of both worlds” because you get both a higher return and lower volatility. It doesn’t matter whether you rebalance the low-beta stock portfolio monthly or annually — the same outperformance occurs, which shows that low-beta investing is a very robust phenomenon.

“Betting Against Beta” is a Winning Stock Strategy

A similar New York University investment study in December 2010 concludes that “betting against beta” (BAB) has a sharpe ratio twice as high as value investing and 40% higher than momentum investing. Wow, that’s a powerful force, and its not limited to U.S. equity markets! In fact, the NYU study found low-beta outperformance in:

18 of 19 global equity markets, in Treasury markets, for corporate bonds sorted by maturity and rating, and in futures markets.

The return of the BAB factor rivals that of standard asset pricing factors such as value, momentum, and size in terms of economic magnitude, statistical significance, and robustness across time periods, sub-samples of stocks, and global asset classes.

Roger Conrad, editor of the market-beating Canadian Edge investment service which recommends many dividend-paying and low-volatility stocks, has favored low-beta stocks for years. During the current stock market turmoil, Mr. Conrad recently wrote to subscribers that “relatively unexciting and low beta stocks provide a good refuge during volatile periods.”

The Reasons Low-Beta Stocks are Undervalued

The obvious question that follows this amazing research finding on low-beta investing is this: why has the stock market remained so inefficient — and for so long — that it continually provides smart investors like us with the golden opportunity to buy undervalued low-beta stocks and mint money safely? Professor Baker argues that the market inefficiency is based on irrational investor behavior, which I discussed under the topic “behavioral finance” in 10 Rules For Happiness and 7 Rules of Investing. Specifically, Baker says that the average investor is willing to pay up for high-beta stocks — which makes them overvalued and produce sub-part returns going forward — because of three behavioral flaws:

1. Preference for Lotteries. Most people would prefer to bet $1 to make $5,000 even if the probability of success is so low — like 0.01% — that the expected value of the gamble is negative: (0.01% * $5,000) = $0.50, which is less than the $1.00 cost of the gamble. In contrast, most investors will refuse the opportunity to invest $100 to make $110 if there is a 50% chance of losing the $100, despite the fact that the expected value of the investment is positive: (50% * $110) – (50% * $100) = +$5.00.

2. Representativeness. A small number of high-beta stocks pay off big time like Internet stocks Amazon.com and Google. But the odds of finding the few big winners among all high-beta stocks is very low. The average investor ignores the low probability of success and buys high-beta stocks on the hope they will act “like” Amazon.com and Google, rather than like the much more numerous losers.

3. Overconfidence. Even if an investor realizes the low probability of finding the few big winners among high-beta stocks, they think they have the investment acument to pick them when they actually don’t. I discusss the problem of investor overconfidence in Invest Like a Woman.

Mutual Fund Managers Make the Same Investing Mistake

Interestingly, Baker says that investor irrationality does not apply only to retail investors, but also infects many mutual fund managers whose fund performance is judged versus a fixed benchmark like the S&P 500. The average beta of mutual funds is 1.10 — higher than the S&P 500’s 1.0. In other words, most mutual fund managers are high-beta investors despite the fact that high-beta stocks underperform! Fund managers are so afraid of tracking error and underperforming their fund’s benchmark index in the short-run, that they willingly take on more risk than is rationale. The result is that the average mutual fund manager chooses a stock allocation that doesn‘t produce the highest long-term risk-adjusted return.

Individual investors can do better than mutual funds!

Low-Beta Stock Screen

In conclusion, smart investors can take advantage of the stock market’s ineffiicency by buying low-beta stocks. With this investing insight in mind, I thought I would perform a stock screen on my trusty Bloomberg terminal to discover which stocks currently sport the magical combination of low beta and solid dividends. If there is any way to survive this down market, investing in the following type of stocks may be the answer:

Top 7 Low-Beta Stocks

Source: Bloomberg