Benefits of adding low volatile stocks to your portfolio.
Investing is a complex field, and investors are always looking for ways to improve their returns while reducing their risks. While there are many factors that can contribute to long-term investment success, some investment factors have been shown to be more reliable than others.
One such factor is the value of stocks. Value stocks are typically companies with low price-to-earnings or price-to-book ratios or higher dividend yields. These stocks often include troubled businesses that investors are hesitant to invest in. However, they are priced to deliver higher average returns than the market, which makes sense. Investors who hold them are being rewarded for taking greater risks on each individual stock.
Another factor that has been shown to be associated with higher long-term returns is investing in smaller companies. Smaller companies are generally riskier than larger ones, so it makes sense that they are also priced to deliver higher returns on average.
However, there is one well-documented anomaly that is hard to justify. Stocks with less volatile share prices seem to outperform. Since investors typically use volatility as a measure of risk, this is hard to explain. The explanation that appeals to many investors is that lower-volatility stocks tend to be more boring and less newsworthy. Brokers, fund managers, traders, and the press tend to be attracted to more exciting stories, so racier stocks tend to be more popular and, hence, a bit more expensive relative to duller ones.
While low-volatility stocks may often get left behind during market booms, they tend to fall less when the market drops. This is perhaps the most important feature of low-volatility stocks. They have lower losses to recoup after a bear market, and that adds up to higher overall returns.
Many investors have tried to take advantage of this anomaly in their portfolios. Large-cap holdings tend towards the duller end of the market, such as consumer staples and healthcare, although some investors also hold a bit of large-cap tech and luxury. This tends to perform well when riskier smaller stocks don’t.
A new study from Pim van Vliet and Harald Lohre at Robeco looks at this approach more rigorously, comparing the benefits of holding bonds and gold in a portfolio with adding some low-volatility stocks. For example, they find that adding 10% gold to a portfolio that is otherwise 50/50 bonds and equities reduces the risk of losses, but it also reduces returns compared to a 50/50 bond and stock portfolio.
However, a “defensive mix” in which the equity part of the portfolio was filled with low-volatility stocks as well as adding gold did better all round. The overall return barely fell compared to a 50/50 stock/bond portfolio, while losses were lower, producing a higher Sortino ratio. Surprisingly, it had less risk than a portfolio that was 70% bonds.
The Sortino ratio is a method of measuring the risk-adjusted return of an investment or a portfolio. It measures the amount of return you get for each unit of risk that you are taking. There are several ways of measuring risk, and consequently, there are a number of different metrics used to assess risk-adjusted returns, which can produce different conclusions.
The Sharpe ratio is perhaps the best-known measure. It is calculated by dividing the excess return on an investment (i.e., the difference between the return on the investment and the return from a risk-free asset such as a government bond) by the standard deviation of the returns (i.e., how much the returns vary over time). The Sharpe ratio treats all volatility alike, whether it’s the result of the asset rising in price or falling. Investors generally don’t feel the same.
In addition to the behavioral explanation put forward by Haugen and Baker, some researchers have also proposed other possible reasons why low-volatility stocks may outperform. For example, it has been suggested that investors may be willing to pay a premium for low-volatility stocks because they provide a sense of stability and predictability in uncertain market conditions. Furthermore, some investors may be attracted to these stocks because they offer attractive dividend yields and may be seen as defensive investments.
Regardless of the reasons behind their outperformance, it is clear that low-volatility stocks have some unique characteristics that can make them a valuable addition to any portfolio. As mentioned earlier, these stocks tend to have lower losses during bear markets, which can help to reduce the overall volatility of a portfolio and increase the risk-adjusted returns. This is particularly important for investors who are approaching retirement or who have a lower risk tolerance.
A recent study by Pim van Vliet and Harald Lohre at Robeco has further explored the benefits of incorporating low-volatility stocks into a portfolio. The study compared the performance of a portfolio with a defensive mix of low-volatility stocks and gold to a portfolio with a mix of bonds and gold. The results showed that the defensive mix of low-volatility stocks and gold produced a higher Sortino ratio than the bond and gold mix, indicating that it provided a better trade-off between risk and return.
Investors should note, however, that there is no one-size-fits-all approach when it comes to constructing a portfolio. The optimal mix of assets will depend on an individual’s financial goals, risk tolerance, and investment horizon. In addition, as with any investment strategy, there are no guarantees of success, and investors should always conduct their own research and seek professional advice before making any investment decisions.
In conclusion, while the outperformance of low-volatility stocks may seem counterintuitive, it is a well-documented phenomenon that investors should not ignore. By adding low-volatility stocks to a portfolio, investors can potentially reduce the overall risk of their investments while maintaining or even increasing their expected returns. As always, however, investors should exercise caution and carefully consider their own financial goals and risk tolerance before making any investment decisions.