Mind on My Money

How to invest wisely

John Nofsinger is an associate professor of finance at Washington State University and a speaker, writer, and scholar on behavioral finance. See full bio

July 1, 2008, Behavioral Economics

High Returns and Low Risk?

That good feeling about a company impacts investment decisions.

Risk versus Return One of the foundational financial theories is that expected return and risk are positively correlated. In other words, high risk goes with high expected return. U.S. Treasury Bills offer no risk and very low returns. Why would anyone buy a risky investment like stocks or mutual funds when they can buy no-risk T-bills? The answer, of course, is that people are willing to take risk in order to achieve higher returns. While this theory of risk and return describes the investment choices quite well, it does not describe how people think about those choices. Indeed, people tend to believe the opposite, that risk and expected return are negatively correlated. They believe that the stocks they like will earn high expected return with low risk!

This behavior is explained by Meir Statman, Kenneth Fisher, and Deniz Anginer from the perspective of "affect." Affect is the feeling of goodness or badness evoked when a stock's name is mentioned. Even before any analysis is conducted, people have a notion whether they believe a familiar company is good or bad. But what does a "good" company mean to an investor? A "good" investment has the characteristics of high return and low risk. Bad investments are viewed as risky with poor returns. Consider an experiment done by Statman et al. using the firms surveyed by Fortune Magazine and their "admired" firm rankings. The list of these firms was shown to high net-worth investors. Some were asked to rate the future return of each firm on a scale of 1 to 10 (10 is highest). Others where asked to rank the firms on risk (10 is the highest). So, if investors view risk and return from the finance theory perspective, then highly return ranked firms will also be ranked as high risk. However, the investors ranked Fortune's admired firms as having high expected returns and low risk. The "spurned" firms were ranked as having low future returns and having high risk. Investors believe that good firms will make them a lot of money at low risk. Bad firms are considered risky and provide a low return. Interestingly, this belief is wrong on average. Historically, the poorly rated companies (the spurned firms) actually outperform the highly rated ones (the admired firms) in the few years following Fortunes' publication.

Yoav Ganzach finds a similar pattern when asking people about the risk and future returns of 30 international stock markets. The stock markets perceived as having high expected return were also perceived as having lower risk.

How does affect hurt investors? Two problems come to mind. First, it tricks investors into believing that good companies are good investments. (See example of this on another post.) In reality, good companies were good investments in the past, but are often underperformers in the future. Second, affect causes investors to under-estimate the amount of risk they are taking. Since they believe they are invested in low risk securities, they may not take the time to purposely reduce risk using ideas like diversification.

(See Meir Statman, Kenneth Fisher, and Deniz Anginer, 2008, "Affect in a behavioral asset-pricing model," Financial Analysts Journal 64(2), 20-29 and Yoav Ganzach, 2000, "Judging risk and return of financial assets," Organizational Behavior and Human Decision Processes 83(2), 353-370.)