Low Volatility Stocks
Excluding stocks and strategies that don’t deliver good returns, in the long run, is critical in the stock market. Of these, you should be particularly wary of stocks with large price fluctuations.
Several academic studies over the years have shown that equities with low volatility deliver better returns than highly volatile equities.
This means that you aren’t rewarded for taking risks. This runs contrary to the learnings of the Capital Asset Pricing Model (CAPM), which is taught in all global financial studies. According to CAPM, high risks lead to high returns.
Risk is measured with a stock’s beta, which calculates how much a stock has moved with respect to the market. The market’s beta is always equal to 1.
If the share’s beta is 1.1, it means that the share is 10% more volatile than the market. It also means that the rise and fall of the stock would be greater when the market rises or falls. On the contrary, the rise or the fall of the stock with respect to the market would be lesser if the share’s beta is less than 1.
In the U.S., there are two ETFs with ticker codes SPLV and SPHB. SPLV consists of shares with a low beta, while SPHB consists of shares with a high beta.
The following chart shows that stocks with low beta (blue line) have performed better than stocks with high beta.
The following table shows the annual returns over the last 60 years for different market capitalizations and volatility:
| Lowest Variance | Second Lowest | Median | Second Highest | Highest Variance | |
| Least Market Value | 16,73% | 17,54% | 15,58% | 10,48% | -2,76% |
| Next Least | 15,20% | 16,1% | 15,64% | 12,99% | 3,43% |
| Median | 13,43% | 13,71% | 14,84% | 13,18% | 5,76% |
| The Second Largest | 12,69% | 13,0% | 12,96% | 12,02% | 6,9% |
| Largest Market Value | 9,72% | 10,87% | 10,15% | 8,95% | 7,81% |
The table shows that the shares with the least market value and highest price variation have delivered negative returns since JF Kennedy was president! Opposite, low volatile small-cap has been the best group.
In 2012, Nardin Baker and Rober Haugen published a note titled Low-Risk Stocks Outperform Within All Observable Markets in the World.
The authors analyzed the low-volatility hypothesis among 21 stock exchanges in developed economies, along with 12 stock exchanges in emerging markets.
The following figures prove that the anomaly exists everywhere.
The result in emerging markets is the same as in developed markets, but with slightly larger differences from one country to another. But Baker and Haugen conclude that volatility should be a criterion regardless of where you buy the shares from.
Even on smaller niche and “commodity” exchanges, the low volatility effect seems to work:
Two students, Adi Grozdanic and Herman Sandnes Munthe-Kaas, have written about volatility in a thesis called The Low Volatility Anomaly on the Oslo Stock Exchange. These two also corroborated that shares with low volatility offer better returns than shares with high volatility.
Why do low beta stocks outperform?
But why exactly do low-beta stocks deliver better returns? Malcolm Baker, Brendan Bradley, and Ryan Taliaferro wrote in the research note The Low Beta Anomaly- A Decomposition into Micro and Macro Effects from September 2013 about three possible explanatory variables.
- Investors are often irrational and tend to gravitate toward big wins even though the probability of winning is almost zero.
- Investors often overestimate the chance of finding great stocks like Google and Amazon. It leads to investments in high-beta stocks in the hopes of hitting the right stock.
- Investors overestimate their ability to pick winners.
Moreover, high volatility stocks have an uncertain business model. It becomes challenging to determine a correct valuation.
Therefore, news and new information have a strong effect on price development. We also find newly established companies that may present a completely new idea or perhaps a break with existing businesses.
It is difficult to pick the few shares that are multiplied, and therefore, it would be worthwhile to invest in low-beta stocks cautiously.