The stock market sell-off late last year was a reminder of how quickly a spell of bearish sentiment can start feeling like a full blown rout. Go-go growth stocks were pegged back, fast momentum plays were pummelled and even high quality firms saw their prices tumble.
Seasoned investors rightly say that short term pain is the price you pay for owning an asset class (equities) that outperforms over the long run. If you can live with periods of fear (of a permanent loss), then stocks offer the best long-term returns.
But not everything in the stock market is equal. Some shares are very sensitive to the daily ebbs and flows of sentiment, while others are unphased by what the market’s is doing (beta). Some swing wildly around their long term average prices, while others are much more settled (volatility). Understanding the difference can help to introduce some volatility diversification into a portfolio.
The low-vol anomaly
In unsettled conditions, shares that are less sensitive to the market mood have been shown to perform better. While these kinds of low volatility shares don’t tend to outperform in bull markets, they can hold up much better when there’s blood on the streets. In fact, over the long term, low volatility (or lower risk) stock strategies have been shown to be the more profitable approach.
This finding was originally made in research by the late Professor Robert Haugen, who claimed that the idea that “high risk equals high reward” was a misconception. He suggested that overconfident investors tend to bid-up the prices of riskier stocks - which then subsequently underperform.
Haugen’s conclusion has since been backed up by other studies. Betting Against Beta by Andrea Frazzini and Lasse Heje Pedersen (of the hedge fund AQR Capital), and The Value of Low Volatility by David Blitz (of Robeco) both find that low volatility is a powerful effect.
Frazzini and Pedersen found that “high beta is associated with low alpha” and that investors gravitate towards riskier stocks in the misplaced belief that they’ll produce superior returns over lower-beta stocks.
How to hunt for more lower volatility shares
Calculating volatility in the stock market isn’t simple. In the case of beta, it’s is a direct measure - often taken over several years - of how sensitive a stock price is to the movement of the wider market. If a stock’s price tends to rise more…
