Why Higher Returns Without Higher Risk Is Possible
In investing, we’re often told that higher returns come only with higher risk. This belief, rooted in the Efficient Market Hypothesis (EMH), assumes that any attempt to outperform the market must involve taking on more volatility. But what if this core assumption is flawed?
In his essay Return Free Risk, Terry Smith, founder of Fundsmith, argues that many investors are accepting unnecessary risk while chasing returns that could be achieved more predictably.
Debunking the Risk-Return Trade-off
The traditional risk-return trade-off suggests a linear relationship between risk and reward. Smith challenges this with real-world data.
One of the most notable studies he cites, by Robert Haugen and Nardin Baker, examined stock performance from 1990 to 2011 across 21 developed countries. The result?
- The least volatile decile of stocks delivered 8.7% annualized returns.
- The most volatile decile lost 8.8% annually.
This inverse relationship completely undercuts the idea that volatility is a reliable proxy for expected return.
For investors focused on understanding real risk, this aligns with our thinking at Finomenon Investments, where risk is viewed as the likelihood of permanent capital impairment, not day-to-day fluctuations.
The Power of Quality: What Really Drives Long-Term Outperformance
If risk doesn’t explain return, what does? The answer may lie in business quality—but not in the vague, anecdotal sense.
A landmark 2012 Goldman Sachs Global Strategy Research report proposed a more empirical definition of quality. The paper made two important contributions:
- It rejected the idea that “quality” could be defined solely by common traits like balance sheet strength or management.
- Instead, it emphasized outcomes—specifically, superior and persistent financial performance.
To measure this, Goldman Sachs used Cash Return on Cash Invested (CROCI) as their primary metric. CROCI had two advantages:
- It transcends accounting standards across regions, unlike income-based metrics.
- It focuses on cash performance, offering a clearer picture of operational strength.
By targeting companies with high and persistent CROCI, they were able to isolate businesses that outperformed peers—without requiring investors to stomach more volatility. This aligns with our own selection process at Finomenon, where we prioritize durable businesses that generate consistent free cash flow and reinvest it at high returns.
We integrate this framework into our Investment Philosophy, focusing on capital-light, high-margin businesses with pricing power, recurring revenues, and strong returns on invested capital.
Behavioral Reasons Behind the Mispricing of Quality
Smith identifies three behavioral forces that cause investors to misprice quality and overpay for risk:
1. Overpaying for Volatility
Investors often chase high-beta stocks in hopes of mimicking leverage. These “exciting” bets attract capital, driving valuations higher—while boring, stable businesses get ignored.
2. The Lottery Ticket Effect
Behavioral finance shows that investors are drawn to speculative stocks, hoping for a big payoff. Like buying lottery tickets, this strategy has poor expected value over time.
3. Mean Reversion Misunderstood
Smith refutes the assumption that high returns must revert to the mean. Companies with durable competitive advantages—brands, distribution, network effects—often deliver persistently superior results.
This directly connects to our view at Finomenon: great businesses stay great longer than markets expect.
A Rational Strategy for Achieving Higher Returns Without Higher Risk
So what should the thoughtful investor do?
Terry Smith recommends a strategy that’s neither flashy nor aggressive:
- Focus on high-CROCI, low-volatility stocks.
- Avoid market fads and speculative leverage.
- Stick with high-quality businesses that compound.
This approach mirrors Warren Buffett’s disciplined use of leverage through Berkshire Hathaway’s insurance float. It’s a smart, risk-aware method of enhancing returns without exposing capital to unnecessary downside.
Final Thoughts: Long-Term Outperformance Starts With Rethinking Risk
Terry Smith’s Return Free Risk challenges the flawed assumptions behind the classic risk-return trade-off. The evidence shows that investors can indeed earn higher returns without higher risk, by focusing on quality and resisting the urge to speculate.
In today’s environment, where volatility is mistaken for opportunity, Smith’s clarity is refreshing.
“What matters in the long run is not what’s exciting, but what’s durable.” — Terry Smith
Disclaimer: Nothing here should be considered investment advice. All investments carry risks, including possible loss of principal and fluctuation in value. Finomenon Investments cannot guarantee future financial results.
