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Low volatility – having your cake and eating it

The low volatility phenomenon is described as an anomaly; like ball lightning or a dog that says “sausages” or sexy popes, it shouldn’t work but it seemingly does.

The promise of low volatility equities is three-fold:

  • Returns that match or exceed the market over time…
  • …while inflicting around 20% less price fluctuation pain upon investors, and…
  • …during a bear market nightmare, total losses that are less severe than the market as a whole.

It sounds too good to be true. The same or better returns for less risk? Yes please, I’ll have some of that.

Most investors will be aware that financial theory warns that you don’t get something for nothing. There’s no reward without risk they say, and so more volatile investments should offer greater expected returns than safer options. Except they don’t.

Low volatility equities have been shown to outperform their high vol peers, offering superior risk-adjusted returns over the course of the last 40 years.

And that’s as weird as a catfish playing with yarn. What are we doing stocking our portfolios full of shares that are about as stable as dynamite when we could get the same results for much less trouble?

The low down

Low volatility equities go cheap

Low volatility is another of the return premiums that concentrate on certain company traits to produce something like a genetically modified super-crop of equities – with the potential to increase the return of your portfolio.

In this case, the low volatility bracket is filled with companies that are relatively less affected by the movements of the broader stock market.

These are known as low beta companies. When the stock market takes a tumble, their prices won’t necessarily fall so far in tandem.

An example of a low beta equity is a power company. Customers still need to keep the lights on even during a recession, so the firm and its share price may be less badly hit than say a car manufacturer when the wider economy heads south.

Equally, if there’s a raging bull market, the utility firm will benefit from the general upswing in demand. But it’s unlikely to get as big a bounce as the car company with its new line of robot-chauffeured roadsters.

The upshot is that low volatility strategies tend to underperform during the good times and outperform during the bad.

Humans don’t learn

None of this explains why sluggish shares should out-perform high beta (that is, high volatility) shares that experience more ups and downs than an elevator operator.

For that it seems we must once again turn to our dumb human brains.

There are a number of theories from behavioural finance that might explain why we accept higher prices and lower returns when buying high volatility equities:

  • We love a lottery. We’d sooner gamble on an overpriced tech company that’s never made a bean in the hope that it might become the next Google than we would invest in some boring dog food cannery that will keep making profits as long as people don’t want to starve their dogs.
  • Overconfidence means we’re convinced we can pick the next Google out of the crowd, even though we know most investors don’t have this skill and most ‘next Googles’ turn into the last GeoCities.
  • Optimistic analyst forecasts for fast-growing equities serve to push up prices and consequently lower future returns.
  • Active fund managers dare not tilt towards low volatility equities for fear that they’ll get fired when they deviate from their benchmark for a prolonged period.
  • We’re not all Sages of Omaha. One way to exploit the low volatility anomaly is to load up on less risky equities and then pump your returns with leverage. ++ Alert ++ Alert ++ Compulsory Warren Buffet reference: Warren Buffet apparently does this with his insurance company float++ End Alert ++ But many investors are prone to leverage aversion. They’re either not allowed (pension funds) or too afraid (me!) to take on the risks, costs, and hassle of borrowing to invest. So instead they lean on high beta assets for extra snap, crackle, and pop but that dependency raises prices and reduces future returns.

A low ebb

Human behaviour being what it is (i.e. mentally frozen in the Paleolithic), there’s good reason to believe that low volatility may survive the ravages of arbitrage as has momentum.

For instance despite the anomaly’s discovery in 1972, low volatility beat the US market by 2% per year between 1963 and 2009, while exhibiting 15% less risk.

However, like all the return premiums, low volatility is not an escalator to dreamland. There’s no guarantee it will outperform in the future and there’s a near certainty that it will underperform for years at some point – testing your will and sanity when it does so.

Indeed, the irony of low volatility’s recent popularity (and the proliferation of supporting tracker products) is that low vol equities may have become significantly overvalued.

As always, when an investing strategy becomes a fad, then there’s a heightened danger that it’s due a strong dose of underperformance. That plus a few other controversies surrounding low volatility are worthy of further consideration.

Take it steady,

The Accumulator

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{ 15 comments… add one }
  • 1 rajkanwarbatra October 21, 2014, 12:32 pm

    Awesome post.
    In my life experience over confidence is the cause of half of all the problems in the World.

  • 2 dearieme October 21, 2014, 9:54 pm

    “when an investing strategy becomes a fad, then there’s a heightened danger that it’s due a strong dose of underperformance”: I suppose that’s true of “equity income” too.

  • 3 Kalen Bruce @ MoneyMiniBlog October 22, 2014, 1:49 pm

    I think people are too quick to see someone like Warren Buffett and think that it’s easy to do what he does. We really don’t learn, like you said. And the lottery…don’t get me started! lol

  • 4 grey gym sock October 22, 2014, 2:31 pm

    if low volatility is a cake, then (some would say) it comprises a layer of not-quite-full exposure to the market, with some extra “value” and “quality” layers, and a bias to big-capitalization shares. see http://www.bogleheads.org/forum/viewtopic.php?f=10&t=147755

    some of the theories for why low volatility might work (e.g. avoiding “lottery” stocks) sound similar to the case for “value”.

    arguably, you do want to know how low volatility is made (unlike sausages), because its make-up may change over time. e.g. it’s been claimed that the “value” layer has disappeared recently.

    i’m not sure what to believe about all this. is the real super-food “low volatilty”, “small value”, “momentum”, or something else? you could try to buy a bit of everything; however, if any of these strategies turns out to be an anomaly that goes away, you will then be holding a bit of it.

    if in doubt, keep it simple.

  • 5 Dave October 23, 2014, 6:38 am

    Anyone any ideas why all these ‘new’ options (momentum, low volatility etc) are not mentioned in books like Smarter Investing?

    I was OK when people just talked about small cap and value (especially as we couldn’t even really buy a value tracker!) but this is all a bit much!

  • 6 sceptic October 23, 2014, 8:04 am


    Because these are built for professional (institutional) investors and not the little man on the street.

  • 7 dearieme October 23, 2014, 11:58 am

    “Because these are built for professional (institutional) investors”: in which case the money flows will soon undermine the correlations, perhaps.

  • 8 The Accumulator October 23, 2014, 12:43 pm

    @ Dave – we can only speculate on why Tim Hale didn’t include these ideas in his new edition – possibly because he felt it was too complicated or because appropriate products didn’t exist (momentum) or have a long enough track record (volatility).

    He extensively references Dimensional Fund Advisor sources (a US provider of passive funds) and they cast low volatility as a form of value.

    They also screen for momentum in their existing funds so that’s a factor they do think is relevant but package it up as part of their current service.

    Personally speaking, I’ve decided against investing in low volatility for the reasons given by Old Grey but I probably will invest in momentum because it’s historically persistent, globally pervasive and negatively / low correlated with the market / small cap / value.

    I’m not going to rush into it though, I’m hoping that someone will come up with a decent multi-factor ETF over the next year or so.

    Finally, Old Grey’s last line is spot on.

  • 9 Hannah October 23, 2014, 4:07 pm

    The Accumulator,

    You DO borrow to invest:

    see “Why I’m not paying off my mortgage”

  • 10 rodent October 23, 2014, 5:25 pm

    I borrow to invest! I have a mortgage and I currently owe 3 times my salary (bought 4 years ago). I have 2 x the value of my salary on the table! (only been in employment 5 years) Somedays it feels as if i’m a poker player!

    Some people drink coffee or alcohol, some take drugs, use escorts. I use leverage to by index trackers! I have a dirtier little secret, I even stooz off credit cards! talk about risky

  • 11 Hannah October 23, 2014, 6:13 pm


    Do you regard investment as a zero-sum game? Funding an investment with a mortgage will tip the average return in the zero-sum gain towards a loss.

    So your choice is to spend all night at the roulette wheel betting red or black (i.e. passive index fund) with bits of your mortgage money. The balance will be tipped towards losing because of the interest payment. Some will have a string of misfortune and heavy losses. The winners walk away with the loser’s house equity.

    Or, you can pay off the mortgage and turn up late to the casino. Bet on one number with loose change. Regardless of the outcome – on average zero so better than the mortgaged crowd – everyone keeps their house.

    I’m paying off the mortgage.

  • 12 The Accumulator October 23, 2014, 6:39 pm

    @ Hannah – really not sure where that came from. This thread is about low volatility. I’ve written an entire article on my choices re: the mortgage as you’ve referenced. Happy to engage there if you like. Here’s a great piece by Michael Kitces that agrees with you: http://www.kitces.com/blog/why-is-it-risky-to-buy-stocks-on-margin-but-prudent-to-buy-them-on-mortgage/

  • 13 rodent October 23, 2014, 9:05 pm

    Hi hannah. In the last year and a bit I cleared 18k off my mortgage. My employer gives me free money for paying into my pension. My life is set up for lots of saving and investment and I’m the least leveraged homeowner I know. I’m honestly not clever enough to tell if investing is a zero sum game but it beats drink, drugs, big TVs,strictly and takeaways. I live an efficient lifestyle. I was hospitalised on march and looked death in the eye and one thing I’m certain of is I need to live boldly and bravely. I love volatility. I read monevator to inform and amuse myself. To be honest I don’t even know why im feeding a troll or even making a permanent mark on the interwebs with such drivel. But I’m rarely certain the maths and logic will prove you cautious

  • 14 The Investor October 24, 2014, 1:08 pm

    Investing in the overall stock market is not a zero sum game — actively speculating in one sub-section of securities versus another subset *is* a zero sum game (because if your subset wins then whoever was on the other side of your subset loses).

    Nobody would invest in shares versus cash if the expected return was zero.

    Over the long-term (113 years to end of 2013) UK equities have returned a nominal geometric mean return of 9% a year / an arithmetic mean return of 11.3%. By the same measure bonds have returned 5.4%/6%.

    If you can lock in a fixed rate mortgage for around 4% today for a decade, say, then I personally like those odds. Even better a mortgage is not marked-to-market (so you don’t face margin calls if house prices oscillate) and most enable some measure of flexible repayments (so you can overpay if the prospective return from equities looks poor).

    Moreover there are different ways to effectively borrow to invest via a mortgage. Using an interest-only mortgage is riskier (because you will face sequence of returns risk on the repayment date, although this can be mitigated as above with earlier repayments) versus a repayment mortgage, where you believe you can safely pay off the 25-year term from salary etc, and save on the side into equities (which is what most people actually do in reality with a pension).

    There’s nothing wrong at all with paying off a mortgage first, but there’s a risk/reward justification for other strategies, too.

    (Apologies if you got the first version of this comment over email and it made little sense — was initially replying with a niece singing into my ear! 🙂 )

  • 15 magneto October 24, 2014, 4:28 pm

    Not quite sure why we are talking mortgages, but anyway :-

    Sometimes overlooked is that the repayment of mortgages is in future devalued sterling. so assuming inflation of 3%, the sums look like :-

    Mortgage 4% – infl = 1% real
    Stocks (UK All Share) 3.4% real
    Gilts (10 year) 2.16% – infl = Horrible

    How about another thread on fixed Interest ???

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