Stock market investors have been dealt some heavy blows over the past three months. Even the FTSE 350 index of large and mid-cap shares fell by 10% during four stomach-churning weeks in September and October. But while there were certainly some hefty individual price corrections, a number of shares in the index were hardly affected at all.
Part of the reason why some shares are able to cope with volatile conditions is actually well known. Not only that, but it has been shown that so-called ‘low volatility’ stocks tend to outperform riskier stocks over the long term. They rise slower in bull markets but don’t fall as far in bear markets. In fact, decades of research suggests that the old stock market adage that high risk equals high reward is complete bunkum.
Meet the Low Volatility Anomaly
Academics and market professionals like Robert Haugen have been writing about the existence of the Low Volatility Anomaly since the 1970s. What they’ve found is that low risk stocks have higher expected returns. There is some debate about precisely why that is. But like many market anomalies, it seems that behavioural factors could be at play. In particular, investors gravitate towards riskier shares and are overconfident about picking winners. As a result, riskier stocks become overpriced and underperform, and that creates a value premium at the lower risk end of the market.
According to investment management advisors MFS, the Low Volatility Anomaly suggests that investors can achieve up to a third less volatility in their equity portfolios without sacrificing benchmark-like returns.
What is a low risk stock?
Researchers use numerous factors when it comes to measuring how risky a stock is. But in the study of low volatility, one measure that is often used is something called Beta. It’s a term that sounds insanely complex but Beta is just a way of measuring how sensitive a company’s share price is in relation to the market.
If a stock’s price tends to rise more than the market on up-days and fall more than the market on down days, it will have a Beta greater than 1. But if it isn’t as sensitive to market movements, rising less and falling less than the market, then it will have a Beta of less than 1. On its own Beta isn’t a measure of volatility. But it can be used as a risk indicator to manage the exposure…
