Most investors still don’t understand the relationship between risk and return, study reveals

The study is titled “Subjective Risk-Return Trade-off” by Chanik Jo of the Chinese University of Hong Kong, and Chen Lin and Yang You of the University of Hong Kong.

It’s a huge deal that, not just a few of us, but the vast majority are just plain wrong about one of the most foundational concepts on which the markets are built. I’m surprised it hasn’t received more notice. Among the Wall Street analysts whose research I regularly read, the only mention I’ve seen is from Joachim Klement, a trustee of the CFA Institute Research Foundation and former head of equity strategy for UBS Wealth Management.

The authors of this new study were able to gain insight into investors’ beliefs by surveying a representative sample of U.S. residents (nearly 3,000 respondents in all) about their subjective attitudes toward the expected returns and risks for several asset classes. A large majority of respondents believed that there is an inverse relationship between risk and return, as opposed to the positive correlation that theory and practice have shown to be the case.

To illustrate, consider real estate versus equities
SPX,
+1.42%

DJIA,
+0.97%

COMP,
+1.88%.
Of the many survey respondents who said that they believe real estate to be the safer of the two asset classes, 77% also said they believe that real estate produces higher returns.

Note carefully that the researchers are focusing on subjective beliefs, not objective reality. They aren’t taking a position one way or the other on whether real estate is in fact safer than stocks, or vice versa. The researchers’ point, instead, is that if you believe real estate to be safer than stocks, then you should also belief its return over time will be lower. To believe that it’s safer and a better long-term performer is magical thinking; you can’t have it both ways.

It’s also worth noting that the researchers aren’t focusing on these asset classes’ behavior over the shorter- or even intermediate-terms. There inevitably will be times when any asset class will be the worst performer among the major asset classes, and other times when it will come out on top. Instead, the researchers are focusing on long-term return — over the several-decade time frame that is relevant to investing for retirement.

This new study’s findings have real-world significance. If we are fundamentally wrong about the risk-reward tradeoff, then we’re likely to make inappropriate investments. On the one hand, we might load up our portfolio with conservative assets that, contrary to our expectations, perform poorly over time. Or, on the other hand, we might load up our portfolio with assets whose expected returns are high but, contrary to our expectations, are far riskier than we think.

What is risk, exactly?

You might wonder if the researchers’ otherwise-blockbuster result is in fact caused by nothing more profound than the well-known failure of most investors to accurately comprehend risk. Many, if not most, of us can’t come up with a cogent definition of what risk really entails. A perennial anecdote among financial planners is that their clients say things like “I’m not greedy, and I don’t want to gamble. I just want to double my money with no risk.”

But this can’t explain what the authors found. They designed their survey to include a number of carefully worded questions that get to the heart of an asset’s risk. These questions sought investors’ beliefs about an asset’s volatility, its ability to hedge against inflation, its liquidity, its tangibility, its ability to generate cash flow and so on. The researchers found that investors’ answers to these questions were, on the whole, internally consistent: Their answers aligned with their beliefs about the various assets’ riskiness.

It’s also worth noting that investors’ mistaken beliefs about the risk-return relationship were not just a function of poor education or lack of familiarity with the markets. They found that the belief in a negative risk-return tradeoff exists also among those with the most wealth, most income, most education and those who score highest for financial literacy.

The bottom line, according to Klement: We need to do a better job educating ourselves about asset classes’ long-term returns and their risk — and the relationship between the two. Once we do that, it’s likely we’ll need to make some fundamental changes to our 401(k)s.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.