What is low volatility investing and why should investors learn about it?
Low volatility is one of the factors investors can apply to select stocks that are more resilient to market downturns. There are low volatility factor funds and low volatility indexes.
The other main factors are growth and value, which are considered in this article, and the quality factor which is considered in this article.
Low volatility stocks are stocks that exhibit lower price volatility than the level of the market. You could argue it is actually a contrarian investing strategy.
The premise is that more investors are seeking higher rewards and therefore they buy into riskier stocks pushing up the prices of the riskier stocks and therefore leaving the less risky stocks at discounted prices.
A bit of a tall order maybe but there is a certain logic to it.
Beta
The measure most frequently used of the volatility of a stock by its beta. Beta is a number that represents how the stock price varies in comparison with the market.
- A stock whose price increases by 1% when the market goes up 1% has a beta of 1.
- A stock whose price increases by 0.5% when the market goes up 1% has a beta of 0.5
- A stock whose price decreases by 0.5% when the market goes up 1% has a beta of -0.5 etc
Working through this myself I am starting to wonder whether this is the best measure for volatility. I guess the logic is that every stock is affected by the market and the market will do what the market does. So when we want to measure the volatility of a stock we should do so using a measure of its volatility relative to the market.
One of the important aspects of Beta though is that it only works for small changes in price. Once the price has moved more than a few percentage points, the correlation with the market and hence the beta of the stock will change.
What goes down has to come back
Or so we hope.
The important point here is that since the market is in constant flux, and resetting and rebalancing itself after every move, a market position that has declined by 20% will then have to regain 25% to get back where it was.
Of course, the math gets worse the more your portfolio may have declined. For example, to recover from a 50% drop, your portfolio will need to double, i.e. regain 100% to get you back to where you started. While that isn’t impossible, it’s quite a tall order.
How does volatility perform over time?
To test the hypothesis on which low-volatility is based, let’s take a look at how stocks with different betas performed over the long-run.
A good universe to start with is the Standard and Poor’s 500 Index. This index tracks the prices of 500 of the largest and most financially sound stocks on the US stock exchange. Actually, the criteria the stocks have to meet to be included in the list are quite straightforward so there they are.
Criteria for inclusion in the Standard and Poor’s 500 Index
- Market capitalization must be at least $8.2 billion
- It must be a US-based company
- Must be listed on either the NYSE or NASDAQ
- Must be highly liquid – minimum monthly volume 250,000 shares traded every month
The list is maintained by a committee that considers changes every quarter. However, they try to avoid constant changes to which stocks are included on the list since the mere act of adding or dropping stocks from the list, moves the individual stock price. The weighting of each stock, i.e. the percentage that each stock contributes to the index is adjusted on an ongoing basis as prices move.
Since the Standard and Poor’s 500 Index is weighted by market capitalization, the bigger market cap stocks have a greater impact on the index. The top 10%, i.e. the top 50 stocks represent 54.4% of the total value of the index. Also, since all 500 stocks capture about 80% of the US markets, the top 50 stocks of the Standard and Poor’s 500 index captures around 43.5% of the US markets so it is a fairly good indicator of what the market is doing.
Top 50 stocks long-term annualized returns vs Beta
Here is the list showing their weighting in the index, their Beta values for the last 5-year period, and the annualized returns each delivered over the long-term with the available data.
1)Data source: Yahoo Finance, all calculations and charts by https://badinvestmentsadvice.com/
This is what the annualized returns look like when plotted against the Beta values.
I think this is why this kind of graph is called a scatter plot. To my eyes, I can’t see any kind of discernable pattern. To be fair this is not an equitable comparison since I did the calculations using the available data and some go back only 7 years while others go back more than 50 years.
Top 50 stocks last 5-years annualized returns vs Beta
Here are the annualized returns counting only the last 5 years from December 2015 to December 2020.
Again, I can’t see any kind of statistically significant pattern here. To prove the point if we add a linear regression line of best fit this is what we see.
Though there is no reason why we should be looking for a linear relationship, without getting into statistical detail, the low value of R squared shows that the data has a weak fit with a straight line.
As I say I want to avoid too much statistical detail but R squared varies from 0 to 1 where 0 indicates no pattern and 1 indicates a perfect fit. To get an R squared of 1 all the dots would be on the line. Generally, an R squared above 0.9 indicates a statistically significant and reliable fit.
Does low volatility deliver low returns?
I don’t think it would matter a great deal if we tried a curve for that matter. But more to the point whatever shape we try to fit it does look as if stocks with higher betas show greater returns which is actually the opposite conclusion to the basic premise of the low volatility strategy.
Reading the research on this topic, it seems that the low volatility approach only works over the very long term taking all phases of the economic and market cycle into account. So 5 years is clearly too short and what’s more the last 5 years from December 2015 to December 2020 have seen mostly rising stock prices.
Low volatility is one of the components of a fund management approach that is called Smart Beta. It is noteworthy that even reliable published sources on the topic show that opinions differ on Smart Beta in particular. But let’s not throw the baby out with the bathwater just yet.
Going back to our original definition, and the basic rationale for the low volatility strategy, we would probably see better results if we looked at long periods of either downwards or sideways market movement.
Annualized returns vs percentage difference high/low price
Working with available data, let’s try another measure of price volatility other than a stock’s market beta. Let’s see whether a relationship is more evident between the annualized returns and price volatility as measured by the percentage difference between the high price and the low price in a given time period.
In this instance, we are using monthly price data. This is what that looks like for our top 50 stocks.
Though you could argue there are still too few data points to draw any reliable conclusions, to my eyes there is a definite upward trend in the results. That uptrend is confirmed by the regression line that has a better value of R squared of 0.56 which is an improvement but is still far from being reliable.
Alpha and beta
Maybe all the analysis above is missing the main point.
What all fund managers seek in their investing strategy is to achieve returns that are greater than market returns. As explained in this article on the capital asset pricing model, alpha is the measure of excess returns with respect to the market returns.
Another way of saying this is that fund managers are in a constant quest for more and greater alpha. One of the principal advantages of low volatility assets is that they lose less of their value when the market declines than do more volatile assets. So there is a rationale for including low volatility stocks in your portfolio, either on a permanent or on an as-needed basis.
Low volatility ETFs
Many of the main fund providers offer low volatility equity and bond ETFs and some target dividend payments together with low volatility. This makes sense because some of the traditional low volatility stocks, such as utilities also tend to pay higher than average dividends.
It is true to say that generally, low volatility ETFs appeal to defensive investors, whether as a long-term position or for short-term defensive stances.
How to use low volatility investments
I will conclude by saying that low volatility is a factor that is best used in combination with other factors including growth, value, quality, and market capitalization in an overall factor-based investing approach.
This article gives more of the context surrounding the low volatility investing approach.
Questions and Answers
Q. Is low volatility investing a good strategy?
A. Low volatility investing intends to minimize price declines when the market drops. On the other hand, it also tries to keep exposure to rising prices. It is a defensive strategy and is good for investors who have a low appetite for and tolerance of risk. It would not be a good long-term strategy for more aggressive investors.
Q. What are low volatility stocks?
A. Low volatility stocks are often found in utilities, drugs, and consumer staples sectors. They are often steady dividend-paying stocks and are considered safe-havens. Low volatility stocks also serve as a barometer for risk. When fund managers and investors start moving into low volatility stocks that is an indicator of a risk-off market. That indicates that fund managers and investors are becoming more cautious about the market.
Q. What is better, low volatility or high volatility?
A. That is a matter of personal preference. If an investor or trader is more aggressive and looking to make short or intermediate-term trades then they will generally be looking for higher volatility stocks. If an investor is more defensive and does not want to see significant declines in the prices of their positions, then it is better for them to be in low volatility stocks.
Single-page summary
Here is a single-page summary of low volatility investing that you can download as a PDF.
I hope you found this article interesting and useful. Do leave me a comment, a question, an opinion, or a suggestion and I will reply soonest. And if you are inclined to do me a favor, scroll down a bit and click on one of the social media buttons, and share it with your friends. They may just thank you for it.
Disclaimer: I am not a financial professional. All the information on this website and in this article is for information purposes only and should not be taken as investment advice, good or bad.
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References
| ↑1 | Data source: Yahoo Finance, all calculations and charts by https://badinvestmentsadvice.com/ |
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Hi Andy
A very interesting piece and with a background in engineering I know a lot about statistics and regression. Often when you have such a correlation coefficient that is low as this, you many have to conclude that there is no relationship between the two variables in the first place. It may be that beta is not a good indicator but the price looks better, a stronger indicator. I never understand why people stick to something that will not show anything whilst price looks much better.
You can say that the trend has been demonstrated. I think there are so many factors in play that this beta number will ignore, so I cannot see being a reliable measure. Has there been another way of determining trends in low volatility stock markets?
Thanks
Antonio
Hi Antonio
I have been thinking about this since looking into the issue. The available reference material I have found is quite vague and suggests that a low volatility portfolio yields superior returns over the very long term when simulating portfolios using 90 years or more of historical stock data. But as you can see I wasn’t able to demonstrate anything like that using admittedly shorter historical periods. Also, the reference material is a little vague about the methods used to build portfolios. One of the inherent weaknesses with beta is that it changes so much when prices move more than a few percentage points. So how can you reliably use beta for a stock over a 5-year period when all prices have moved often as much as 50 to 100 percent either down or up cumulatively. I would want to see how much beta varied over that period to be sure that beta really is stable enough for this kind of long-term analysis.
Smart-beta funds, which often incorporate low volatility approaches were popular and did well after the 2008 market crash, but the word now is that they have not fared so well over the last few years.
Looking back at the early article on factor investing, I find it interesting that the traditional wisdom, that the worse performer one year became the best or nearly the best the next year failed in 2019. I should redo that analysis incorporating quality and low volatility factors. That will be a task for another day.
Thanks for the question and best regards
Andy
Low volatility stocks don’t give you heart attacks, but probably they would give you low returns too. I think it depends on your risk appetite. If the stocks give a return that is close to certificates of deposit, I wouldn’t even bother with low volatility stocks because I would just put my money in certificates of deposit, which are guaranteed by my government where I live.
Hi and thanks for the comment. I am inclined to agree with you. Low volatility stocks hardly seem worth it at least not in the current economic environment and certainly not as a long-term position.
Thanks for sharing this post. I’ve been listening and watching videos about low-volatility stocks on YouTube. More precisely, it was a clip by Robert Kyosaki, the author of the “Rich Dad, Poor Dad” book and he said more or less the same things as you have.
I have to say that this field of investing is completely new to me, but I’m learning a lot from your sites and other alike resources. Thanks for elaborating this topic.
If I’m not wrong, low volatility stocks have made Warren Buffet one of the richest man alive. He was investing in long-term stocks (companies) that he believed will grow slowly but steadily in the future over the long-term period.
In any case, thanks a lot for sharing this post. I will have to come back to your site from time to time to learn about this type of investing bit by bit. For a beginner, it’s all too much information at once. However, at least I know you’re the expert and your opinion is much appreciated!
Thanks!
Hi Ivan and thanks for the comments.
I think it is more accurate to say that Warren Buffet’s main criteria for seeking out long-term investments earlier in his career were the quality of the company and management and the unassailability of the brand identity. The mix of attributes that Warren Buffet was using was more akin to the Quality factor.
This article explains how to identify stocks that meet quality criteria.
Many quality stocks will also have low volatility attributes and many low volatility stocks will also have quality attributes. It is quite clear that the two factors overlap a great deal. But low volatility factor stocks can stay that way for a long time and not grow in the same way that quality factor stocks are more likely to steadily grow. Utilities are often low volatility factor stocks and may just steadily pay out dividends and not grow very much at all over the long-term.
Thanks again for your thoughtful comment.
Best regards
Andy
Hi Andy,
Thank you for your article. I had started my investment with some low volatile stocks as I was new in the market, but for long term profit there needs to be a risk factor involved. I believe it is good to have a bit of mixture and invest in both low volatile and risky assets in order to be succesful in stock investment .
Kind regards,
Yoana
Hi Yoana
Congratulations on making your first investments in stocks. In truth, all of us are learning in the investment field. I agree with you it is best to have a mixture of stocks and ETFs in your portfolio. One of the most important aspects of investing is to adopt an approach that you are comfortable with. You should find that is something you get better at over time as you gain experience and learn what kind of an investor you are.
Good luck and best regards
Andy
Hello Andy, thanks for casting the light on low volatility investing. It was interesting to learn that low volatility can serve as an indicator of increased caution amongst investors. Personally, I would probably start with this way of investing, since I wouldn’t like to take great risks at the very beginning of my investing path. I would probably consider investing in real estate – I was quite pleasantly surprised that it falls under the low volatility category. I wonder if you would recommend that to me, a complete beginner…But, on the other hand, it may be rather frustrating not to see any considerable returns, so I guess it may be wise – provided one can afford it and doesn’t put all their savings at stake – to make a risky investment at the same time and see what works better in the long term. Thanks again for your advice and all the useful information!
Hi Lucie
If you still have many years of earning and investing ahead of you one of the most reliable ways to build wealth will be through regular monthly payments into stable tax-efficient investments like index-linked funds. I am assuming that you are not carrying any significant, high-interest debt. If you are carrying high-interest debt and you are only comfortable with low-risk investments, then you should put a plan in place to pay off your debt first as that will give you a better return than low-risk investments. I am not including a mortgage on a primary residence here, that should be at a low rate of interest anyway.
I agree that it makes sense to gain exposure to real estate and there are different ways to do that. You can invest in REITs directly or in REIT ETFs. If you are comfortable with a long-term horizon, for example, there are REITs designed to payout very small steady payments for a period and then 5, 10, or 15 years down the line yield a large payout after properties have appreciated and been liquidated.
If you are interested here is something to check out.
Diversify Fund
Full disclosure here – I am an affiliate.
I have been looking at this myself and I will probably start with a small position.
In these times I would avoid taking any position in commercial real estate though and I would only stick with residential. Commercial real estate is bound to be impacted by dramatic increases in office remote working, even post-pandemic. So I would be careful on that front. REIT ETFs with significant commercial real estate holdings would fall into that category. That is my personal opinion.
I hope this helps.
If you have
Hi Andy,
Thank you for providing so much excellent information! I have some stocks in Robinhood, but I am most definitely a novice investor; I only know the basics and only have a little invested, but it’s invested in a wide variety of types of stocks.
I have kind of come to the same conclusion about low-volatility stocks, mostly because how very little I’ve made on those after the two years I’ve owned them, and how much more I’ve made (and how much more quickly) with the ones considered more volatile. My strategy so far has been investing mainly in companies that I believe in and that I believe will be profitable in the future, trying to diversify my profile, and by not touching my low-volatility stocks.
I feel validated by your article, and I feel like I’ve learned a lot! (I hadn’t known about using beta scores to measure volatility; I just went off of the summary in the app). I also have more questions; though: do you recommend buying and selling volatile stocks as soon as they have made a decent return? Or do you leave those sit as well?
Again, thanks for such an informative article!
Hi Jade
You raise the point of whether it is a good idea to sell volatile stocks as soon as they have made a decent return. There are many aspects to the issues around this. I would say there are a number of things you would need to sort out first. First and foremost would be what kind of investor you are. Are you investing for the long-term and do you expect to hold positions for the long-term and ride out market advances and declines or are you going to seek to move in and out more rapidly only staying in positions as they are profitable. Here are some other articles that should help.
Stock Investing 101.
Steps to take before you invest.
If you are comfortable you know yourself as an investor, going back to your question I would suggest that you look at all the positions in your portfolio and seek to determine – what the target price is that you expect it to reach over what time frame, in other words, what would it look like to you for you to consider that the position has met your expectations and you are ready to exit the position as a winner. On the other hand, you also need to determine what would cause you to exit the position, accepting that it did not meet your expectations and you exit the position as a losing position.
Going forward I would suggest that you try to adopt the same approach to every new position, before you enter the position. So you know beforehand when and where you will exit taking profit, and where and when you will exit taking a loss.
How you actually go about making those decisions will be determined by what kind of investor you are. If you are looking for long-term value positions then you will be following an approach proposed by Benjamin Graham. If you are looking for growth stock opportunities, then you will be following an approach more akin to that proposed by William O’Neil.
There are many aspects to this, you should find many other articles here that can help you make investing and trading decisions that work for you.
Best regards
Andy
Andy,
I was reading the comments that you had responded to and I have to agree with the commercial real estate that you mentioned in response to Lucy. I do think the commercial real estate market may continue to plummet, even through the next few years.
Many businesses in Alaska have decided that the employees can easily work from home and have started shutting down the office buildings because of it. My sisters company, a big oil company up here, would rather save the hundreds of thousands of dollars on their rent and simply have all staff stay home and continue to work. It makes me wonder what will happen to the market in Alaska long term because of this.
Many RE agents are claiming that it’s still a buyers market, but having a RE background, I know this isn’t the case. I see a ton of properties, even residential, popping up on the market every day and not a lot of homes are being sold.
Up here, our prices are very high, much like Hawaii actually. The average price of a residential home is $100K per bedroom. The commercial side though, is much, much higher.
I have to admit, I had tried learning to invest in stocks myself, but I am a newbie and only know the trading side. I didn’t start investing since my husband and I have high interest debt, and you also said to Lucy, it doesn’t make sense to stack money in investments if you’re pouring out your monthly income to debt. I’m still trying to recover from the 2008 crash, in which I lost everything and had to start over. Then alas, 2020 happened, and so it begins again. Rebuilding after still rebuilding from the first time. Makes a person have a whole new perspective on what’s important.
Thanks for sharing this information. While I am new to the investment world, I’m sure this information will be valuable one day when I’m no longer attempting to come back from a total loss of all assets and income.
Katrina
Hi Katrina
Thanks for sharing your story. I am very sorry to hear about the difficulties you have faced and continue to confront. My heart goes out to you.
I agree with you that we have barely started to see the impact that the COVID experience will have had on commercial and residential real estate particularly in cities. For example, most of the big skyscraper properties in the financial district of Manhattan and in mid-town and I think in London have been occupied either zero percent or up to 10 percent since March 2020 and yet the businesses have been operating mostly without interruption. You are probably correct that residential real estate in cities will also be hit as people are likely to make the calculation that if they are only going to be going into the office 1 or 2 days a week, then they can tolerate a longer commute and move out to live somewhere where their dollar goes further and real estate taxes are lower.
It is very true that major disruptions in our lives are major learning and self-discovery opportunities. I have experienced minor blips but nothing like on the scale you describe. I sincerely hope that you are able to build back your assets, savings, and investments. Alaska sounds like a great place to live. I guess there could be a lot worse places to be.
Kind regards
Andy
Thanks for the article on low volatility investing. First off, I am still in the early stages of building my investments and I am still learning a great deal about how best to go about it. Since I am investing for the very long term I am not so worried at this stage about low volatility. I am more interested in long term growth. But I think this advice will be useful for my investing plan down the line. Thanks.
Hi and thanks for your comments. I am glad you found the article interesting and useful. Best regards, Andy
As we all know that high risk equals to high returns but there is also a fact that you should not just put all your eggs in one basket either. I think that we have to know ourselves first what type of investor are we and how much can we tolerate risk and take it from there. It is good to know the investing strategies but you have to know what type of investor are you as well so you are not stressed over it.
Hi and thanks for your comments. I agree with you 100% that it is essential to know what kind of investor you are, what is your risk tolerance, and what is your risk appetite. Experience shows that if you start investing in a way that doesn’t match your risk tolerance and risk appetite then you will abandon it at some point either because you find the ride too unpleasant or because you get bored. That leads to inconsistency in approach which tends to result in a worse than average outcome.
Here is an article about general investment planning.
And here is an article that walks you through working out your risk tolerance and risk appetite.
Hi Andy,
Interesting article, I was unsure at first if I needed “Bad Investment Advice” but after reading discovered how to avoid it!
I am definitely an amateur at investing because I am only mildly involved. What I do know is the key term here is long term. You have to invest and continuously do so for anything to compile. This information lines up with the majority of my portfolio. I have about 80% invested along these lines and split the other 20% in more volatile markets hoping for a higher turnaround in the next few years before retirement.
I have been doing this for about the last 15 years and have piled up almost 1/4 of a million with about $40 a week investing. Like I said I am not an investment genius but this proves to me it does work.
Great layout of information, I will be checking some of my investments against the S&P 500 top 50 you had mentioned.
Thanks,
Chad
Hi Chad
Thanks for your comment. That is a very solid approach to take and I commend you for seeing it through over a 15 year period.
Wishing you all the best
Andy