How To Defend Your Portfolio With Low Volatility Stocks

28th Jan '22 by Ben Hobson

21 comments 4520 reads

There’s a saying in investing that “time in the market beats timing the market”. In other words, long-term trends in stock markets are overwhelmingly positive. The longer you stay invested, the more you can take advantage of the compounding effects of being exposed to them.

On the other side of that argument however, is the idea that selling up when you anticipate volatility might save you from the agony of near term losses. Given that humans feel the pain of loss so much more than the joy of gains, the tendency to avert losses is a very powerful influence. When prices start falling, panic sets in quickly.

The risk of making poor decisions in a panic is a big reason why “time in the market” has become accepted wisdom. In particular, it takes away the need to make correct decisions that would be tricky in calm conditions, but near-on impossible in moments of high stress. To put that another way, timing the market increases your chances of being wrong in a couple of critical ways…

First, it means choosing the optimum moment to sell and get out before prices fall. But it also means you have to judge the optimum time to buy back in. From a psychological perspective, being right about both is an extremely tough call.

Terry Smith, the plain-speaking British fund manager, once wrote that “when it comes to so-called market timing there are only two sorts of people: those who can’t do it, and those who know they can’t do it. It’s safer and more profitable to be in the latter camp.”

So in summary, staying invested in the market as long as possible can make a lot of sense. But does that mean you should simply soak up periods of heightened volatility, when prices may be falling sharply?

The answer is that there’s no single way of immunising a portfolio against broad market sell-offs. But there are tactics you can employ - when you’re either selecting stocks or seeking to understand the profile of existing holdings - that can guide you on how they might behave in the face of volatility and market distress. There are no magic rules, but a few key checks could be worth keeping in mind.

How to defend against volatility

It’s no secret that some stocks (and even entire industry sectors) are less sensitive than others to the…

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Wimbledonsprinter

28th Jan '22

The average beta (to a specific index) of all stocks (in that index) is, by definition, +1. Therefore, you can assume that +1 is an average beta. The very occasional stock will have a negative beta.

Beta is measuring the how the stock price has correlated historically to the moves in the index. Volatility is measuring something slightly different, as Ben explains, it is measuring the amount that a stock has moved historically per day. If you pull up the quote detail of a stock on Stockopedia, it will tell you the volatility of the stock. A volatility of 16%, roughly means the stock moves on average by +/- 1% per day. A volatility of 32%, roughly means the stock moves around 2% per day. Unlike beta, the volatility of the index will be lower than the volatility of average stocks making up that index, because of the diversification effect.

marienee33

Really helpful. Thanks

Tree

The average beta (to a specific index) of all stocks (in that index) is, by definition, +1.

I agree that 1 is a 'par' score, and in practice average betas on an index probably would be somewhere quite close to 1.

Is it necessarily mathematically true though that average beta across index constituent must be 1 exactly?

Maybe I'm taking your statement more literally than you intend here... if so, apologies.

It's probably also of little practical importance. I'm just wondering if I'm missing something in my own understanding of how indices and betas are calculated that doesn't allow me to reach your conclusion...

simoan

Ben,

This is a very thorny subject. You can’t conflate risk and volatility like this, they have nothing to do with each other if your definition of risk = probability of capital loss. There are many flavours of risk but none can be easily measured, least of all using standard deviations. What was the Beta for the UK banks in 2007? What was the Beta of Carillion before it met its maker?

Howard Marks reserved three chapters of his book “The Most Important Thing” for discussing risk that are well worth reading. He makes clear that volatility is not a good measure of the risk of capital loss. I believe he’s also covered the subject in his memos.

All the best, Si

Taras73

29th Jan '22

Many thanks Ben for your very helpful article. For beginners like myself is a great help to understand the fundamentals. Looking forward to your next article!

Hi Taras73,

As a beginner, if you want to understand more about risk I would suggest you read "Fooled By Randomness" by Taleb. Also the excellent Howard Marks memo on the subject: https://www.oaktreecapital.com...

Most important of all, risk and volatility are not the same thing unless your definition of risk is really strange! The use of Beta to quantify risk is just an academic concoction.

All the best, Si

cmpeckham

It is not true to say that risk and volatility "have nothing to do with each other". They certainly do.

For example, buying a volatile asset increases the risk that it will be lowly valued at a time when you are forced to sell. Look at basically every slump in history. Everything goes down together at a time when people are losing their jobs. If you need to sell assets at that time, you'd better hope you bought some less volatile ones because that reduces your risk.

Or, look at a simple ladder of increasingly risky investments. From their fundamentals, we know that cash is less risky than govt bonds, which are less risky than corporate bonds, which are less risky than stocks. It is no coincidence that the historical volatility of these assets correlates with increasing risk.

Risk and volatility are not the same thing but volatility is often used as a proxy for risk for the good reason that it's the best thing we have available and historical data demonstrates the relationship between them. To say that they have nothing to do with each other is just wrong.

Well, we'll have to disagree then. Please read the Howard Marks memo. I completely concur with it. It depends what your definition of risk is. If you mean "risk of capital loss" then knowing the volatility is not going to help you. As Ben points out in his article, share prices can be volatile for all kinds of reasons e.g. liquidity in small caps in particular can cause excess volatility which is not representative of the risk of holding the underlying asset.

For example, buying a volatile asset increases the risk that it will be lowly valued at a time when you are forced to sell. Look at basically every slump in history. Everything goes down together at a time when people are losing their jobs. If you need to sell assets at that time, you'd better hope you bought some less volatile ones because that reduces your risk.

But that's just one very specific risk. If you don't need to sell the risk disappears! If you are going to use volatility = risk then it needs to be used in a more generic way to be meaningful. Risk is better judged at a portfolio level than each individual share for which some people (funds etc.) use the Sharpe ratio.

Sorry, yes I was probably over-egging it. It is only a proxy and as such not much use if you're main concern is permanent capital loss. It didn't help just before the GFC and it didn't help before various companies went bust although they had low Betas at the time. Risk of capital loss for individual stocks is most obviously found on the balance sheet and that has nothing to do with price volatility.

FREng

Si, Thanks for the link to Howard Marks's memo. It was well worth the time spent reading it.

Thanks Si for your reply and an excellent article by Howard Marks (I got his book as well so definitely going to read it now). I guess in Stockopedia they use Beta (volatility) of a company as a measure of its "riskiness"? Perhaps it is a necessary oversimplification but taking it from Howard's article how could you boil it down, to what? There are so many contributing factors, and most important ones are human...What is volatility and what its cause? Again, I've been only investing for 2 years but what I've seen so far is that people over-reaction drives this volatility a lot - a stampede to buy, and to sell. And the cause? - news, traders, analysts, BBs, price movement, etc. and a combination of those. And fundamentals of the company almost certainly ignored.

I guess Ben was trying to explain this feature on stockopedia - beta/volatility which within the current market circumstances is timely I think - especially for the day traders! This aspect should be definitely in their tool box of risk management because their investment horizon is so short?

Anyway, thank you both Ben and Si for some thought provoking Saturday!

Bell Capital

Great article Ben.

Here is a useful blog for any new investors who haven't experienced the current volatility we are seeing. What is Stock Market Volatility? | Money Mentor (money-mentor.org)

DWit199

30th Jan '22

I guess in Stockopedia they use Beta (volatility) of a company as a measure of its "riskiness"?

No need to guess. The explanation is here

"If you don't need to sell the risk disappears!"

I suggest you read Paul Scott's blog and see how many times he's been forced to sell, including within the last few months. If you want to get an idea of how common his situation is look at the margin debt on the NYSE. It's not just to do with leverage either. In 2009, as in many previous slumps, many people had to sell because they'd lost their jobs and needed to pay the mortgage. Volatility gives you the risk of needing to sell at precisely the wrong time.

So you are wrong to say that "knowing the volatility is not going to help you". It certainly does. Choosing less volatile assets is, on average, less risky and will help you avoid capital loss. You're also wrong to say "It didn't help just before the GFC". It certainly did. Going in to 2008 with less volatile assets like cash and government bonds would have helped many people avoid catastrophic losses. Equally, going in to the recent correction with less volatile stocks like giant consumer staples, rather than volatile small cap speculative shares would have helped greatly too (ask Paul).

You're also wrong to say that "Risk of capital loss for individual stocks is most obviously found on the balance sheet". That's one source of risk but just part of the picture. There are all sorts of other risk factors such as cyclicality, operational leverage or customer concentration. Look at £GSK . Terrible balance sheet - not very risky. It's not a coincidence that its low volatility gives it a stocko risk ranking of conservative.

Does low volatility work all the time? Of course not. You seem to think that some stocks with low betas going bust invalidates the whole concept. It doesn't. If you expect perfection you are always going to be disappointed. To borrow a phrase from Statistics, "all models are wrong but some are useful". Volatility is just one model to use in assessing risk. You might dismiss a model because it is imperfect but I wont. I know that imperfect is all we've got.

p.s. I'm picking out the things that you get wrong here, but I'm not saying that beta is a perfect tool or that you are entirely wrong. For example you say that: "Risk is better judged at a portfolio level". I agree on that one and believe it is an important point.

31st Jan '22

I'm sorry but you're conflating multiple risks here. And you've introduced the volatility of financial instruments other than equities - that's cheating! That's not what we are discussing here with regard to Ben's article about the individual company volatility measurement used by Stockopedia as a Risk Rating. That's a pretty big Straw man you have built for your argument to cover up for the fact it does not hold water!!! And thanks for telling me I'm 100% wrong. I love it when people see the world in black and white. That kind of overconfidence is what loses you money. All I see is a mass of different shades of grey, uncertainty and probabilities with regard to investing.

Anyway, you've made a huge, huge mistake here which makes me question whether you understand risk at all. You can't take the risk indicated by volatility and then combine it with the risk of using leverage!!! What a ridiculous thing to do. If you use that combination then even very low beta investments can become very risky e.g. spread betting on indices. Ask Paul about that one while you're at it. The Beta shown by Stockopedia will not help you when you're leveraged to the hilt.

No, the only risk that matters to investors in shares of trading companies is that of capital loss, and the Stockopedia Risk Rating will not help you there. You need to look at the balance sheet. Paul understands this completely (and in 22 years posting on BBs with Paul I can't recall him ever worrying about volatility, in fact I'd say he embraces it) and there is not a company he comments on where he doesn't look at the balance sheet and assess the risk of capital loss. Hardly a day goes by when he doesn't point out negative NTAV situations because if a company needs to prop up a weak balance sheet and do a discounted placing then that is a real form of capital loss, and if the balance sheet is very weak, potential PERMANENT CAPITAL LOSS. The volatility up until any announcement could have been very low and gave you no indication whatsoever you were about to lose your capital. The balance sheet is where the bodies are buried and where the advance warning is.

Sorry, but I can't be bothered to reply to the rest of your post. I have better things to do today. The point is, that volatility is not the main risk that investors in company shares should concern themselves with. Please read the Howard Marks memo. You may even learn something about risk.

simoan,

do you think the "low volatility" anomaly (factor) exists?

Josh543

Great article Ben.

Another method for finding companies that can withstand more volatile high inflation times seems to be assessing their pricing power. Morgan Stanley has an interesting read on this https://www.morganstanley.com/...

It says the best quantitive way of finding these companies is by assessing gross margin and margin stability. Not sure if margin stability is a measure we can use within stockopedia screens though or what peoples thoughts are on this?

Of course I read the Howard Marks memo and I agreed with almost all of it. You seem to think you're saying the same things as he did. You're not. When you say things like "risk and volatility have nothing to do with each other" or that volatility is of no relevance if your definition of risk is permanent capital loss, you're making statements that are demonstrably false. That's why I said you're wrong.

Lets' start with the balance sheet that you seem to regard as the ultimate statement on risk. If I tell you that company A and company B both have £100m of assets and that company A has net cash of £10m and company B has net debt of £10m, do you think that tells you anything about which company is riskier? It doesn't. If I start to look outside the balance sheet and tell you that company A has free cash flow of -£10m and company B has free cash flow of +£10m does that tell you a lot more? It does. If I then tell you that company A has just been sued by the government for £50m does that fill in the picture too? It does. I could go on, but the point is that it the balance sheet on its own tells you very little and whatever it does say is likely to be dominated by other information. That's why, for example, Glaxosmithkline (LON:GSK) is low risk despite a terrible balance sheet.

Conversely, if you tell me that company A is 2 times more volatile than company B, I can immediately tell you that it is probable that company A is more risky than company B. You can stare at the balance sheet all day and not see anything meaningful about the risk associated with that company. In contrast, a 5 second glance at the volatility, or the beta, or the stocko risk rating, will tell you a lot. Does it tell you everything? Of course not. Does it tell you more than studying the balance sheet for 8 hours? Yes.

And it really makes no difference that you want to define risk as permanent capital loss. Capital loss is capital loss. Don't kid yourself that paper losses aren't real losses, or that it's not a loss unless you sell. They're real losses alright and this matters because in the real world most people don't have much choice about when they sell. Almost all investment is for rainy day protection or retirement. We can't control the rainy days and most people can't control when they retire. Some can flex it by a few years but not much in reality. So we all become forced sellers in the end and if the markets are down for a few years when we have to sell, well that's just tough. That is one of the most important ways that volatility and risk are linked.

Speaking of which, going back to the Howard Marks memo, I suggest you look again at the diagram at the bottom of page 2. This is an excellent representation of the relationship between risk and reward. One reason that it's excellent is because with 2 seconds thought the reader can also see the relationship between risk and volatility. It really is staring you in the face. I suggest you take a look.

1st Feb '22

"... the only risk that matters to investors in shares of trading companies is that of capital loss, and the Stockopedia Risk Rating will not help you there. You need to look at the balance sheet. Paul understands this completely"

Just catching up on the SCVR for today, I see that one of Paul's shares Joules (LON:JOUL) has fallen by 45% today. It's just one example, but which was the better predictor of this capital loss, Pauls's assessment that the balance sheet was (and still is) fine .... or the stocko risk rating of Highly Speculative?

9th Feb '22

Yes. Just to be clear I was not arguing against being able to make high returns from low volatility shares.

It's not false, you've just chosen to misinterpret it. It sounds like it is you that is wrong. The risk associated with volatility is only the risk of not sleeping well at night. That doesn't count in my book because that should only relate to overall portfolio volatility, not individual shares within it, which is what we are discussing here. If your portfolio is unbalanced then that's a different kind of risk regardless of volatility.

I note with interest what Keith Ashworth-Lord said about risk and volatility in his January newsletter:

"Equally foolhardy is the premise that risk and share price volatility are somehow equated. Risk is defined by permanent capital loss, not volatility. The Efficient Market Hypothesis has much to answer for in this respect by misguiding investors."

This idea that something as complex and grey as investment risk can be reduced down to a single number is ridiculous, especially when it is a measure of something other than the probability of permanent capital loss. I think Stockopedia know this, and so I don't understand why this article states that risk and volatility are directly related for individual shares. Just because something can be calculated it doesn't make it worthwhile or useful.

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Ben Hobson

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