In uncertain times, investors who want low risk while preserving their capital may seek investments with low volatility.
The values considered low volatility do not fluctuate as much as other investments.
“If you’re thinking why someone would buy a low volatility investment, [they] have a desire to reduce risk,” says Sam Febbraro, executive vice president of Investment Planning Counsel.
But there is a compromise. It is difficult to reduce risk and convert performance on the moon.
As a result, these investments can sometimes underperform in a rising market.
But in theory, they should be less volatile to the downside.
A low volatility investment strategy focuses on reducing volatility or risk relative to the stock index, says Jeet Dhillon, vice president, and senior portfolio manager at TD Wealth Private Investment Counsel.
“Low volatility strategies use risk as the primary metric to determine whether to include or exclude particular stocks and what the optimal weighting will be for stocks included in a portfolio.”
What is Low Volatility Investing?
Low volatility investing is a style of investment that buys stocks or securities with little or low volatility by avoiding those with high volatility.
This investment style utilizes the Low Volatility anomaly.
What’s this Low Volatility Anomaly?
According to financial theory, risk and return should have positive relationships. However, in a real-life situation, this is not true.
Most low volatility investors aim to gain market-like returns, but with lower risk.
Why Does Low Volatility Investing Strategy Matter?
Simple calculations tell us that the more stock’s price falls, the more it must earn to return to equilibrium.
Let’s see what that means.
First, if a stock loses 10%, it must gain 11.1% to return to balance.
And if a stock loses 25%, it must gain 33% to return to balance.
Then, if a stock loses 50%, it must win 100% to return to balance.
Finally, if a stock loses 80%, it must gain 500% to return to balance.
While volatility can cause a stock’s price to spike, it can also cause declines.
In the long run, it may be more difficult for a high-volatility stock to recover what it has lost.
Types of Low Volatility Investment
Many people think of Cash, GIC, and Bonds when they think of low-volatility investments, but stocks and ETFs can also fall into this category.
Dhillon adds that utilities and consumer staples are examples of low-risk stocks because demand for goods and services from these companies is less cyclical.
Therefore, these values offer certain stability in the face of fluctuations in the economy.
Cash and GICs have low volatility because there is no risk of losing the amount initially invested (called principal).
Bond agreements, also known as covenants, also promise that the principal will be repaid when the bond matures. Bondholders often receive interest payments, called coupons, at regular intervals.
In times of high volatility, the value of bonds does not fluctuate as much as the value of stocks. Because the returns on fixed-income securities are affected by long-term trends, such as changes in interest rates.
You can also invest in a low-volatility ETF. These ETFs can include companies considered low volatility, such as consumer staples, real estate income trusts (REITs), and utility companies.
What are the Different Types of Low Volatility Strategies?
Low volatility investment strategies take advantage of the low volatility anomaly.
A generic low volatility strategy selects stocks based on the volatility of past returns.
From an investor’s perspective, such a quantitative strategy offers higher risk-adjusted returns, as measured by the Sharpe index.
This ratio indicates the extent to which investors are rewarded for the (absolute) risk they take.
In other words, how much return they get per unit of risk they take.
Let’s see the different types of low-volatility investment strategies.
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Reasons To Use A Low Volatility Investing Strategy
There are several reasons why the low volatility factor has the potential to outperform the market as a whole in the long run:
#1. The Lottery Effect
Investors can treat stocks like a lottery ticket, seeking higher returns by buying relatively riskier stocks.
This “lottery effect” raises the price of riskier stocks and results in a systematic undercutting of less risky and underprivileged stocks, which can cause out-performance.
#2. Leverage Aversion
In financial theory, due to the efficient market assumption, investors learn that the only way to outperform the market is through leverage (borrowing to buy more of the market portfolio).
However, many investors have a restricted way of using leverage in their portfolios.
As a result, for the additional risk, they buy riskier or riskier stocks, which leads to the kind of lottery effect described above.
#3. Limits to Arbitrage
In many cases, institutional investors are judged on their performance against a fixed benchmark.
As a result, they build their equity portfolios to match industry exposures within a benchmark such as the S&P 500 or Russell 1000.
But pure low-volatility strategies are built from the ground up and include less volatile stocks, regardless of what sector they are in.
As a result, low volatility strategies can have large tracking errors or significant deviations in their industry exposures from the benchmark.
For this reason, the benefits of the low volatility anomaly are not valued or arbitrated and are allowed to exist in the market. Institutional investors have little incentive to arbitrate the anomaly.
While volatility can cause a stock’s price to spike, it can also cause declines. In the long run, it may be more difficult for a high-volatility stock to recover what it has lost.
More risk equals more return. This is a common misconception among investors.
While highly volatile stocks can produce impressive return increases, academic research has found that low volatility stocks have historically delivered better risk-adjusted returns over time.
This is known as the “low volatility anomaly” and is the reason many long-term investors have included low volatility factor strategies in their portfolios.