One of the basic tenets of finance is that risk and return go hand-in-hand – higher returns can be achieved by taking on higher risks. Therefore, investors often expect stocks with lower risk to underperform the market. However, evidence collected over the last 5 decades suggests that stocks with lower risk (or low price volatility) tend to outperform the broad-market over the long-term. This may seem counter-intuitive but it holds true in equity markets around the world, including in India. It is also famously dubbed as the “greatest anomaly in finance”.
What is Low Volatility investing?
Low Volatility (herewith referred as “Low Vol”) investing follows a very simple strategy that aims to buy a portfolio of stocks that exhibit lower price volatility (and therefore are less risky) – i.e., stocks that showcase higher price stability. Such strategies generally pick up on companies with relatively mature business models and stable earnings visibility (think of stocks from consumer staple / durable sectors). Strategies based on Low Volatility tend to fall less during market crashes than broad-based equity, offering good downside protection to investors. However, they also tend to rise less than broad-based equity during bull markets.
Why does Low Vol outperform over long-term?
If Low Vol outperforms during falling markets but then underperforms during rising markets, where does the long-term outperformance come from? A few possible reasons for this are given below –
- Downside protection – Low Vol strategies tend to fall less than broad-based equity when the market experience a sudden crash. We looked at all 13 instances over the last 17 years where the market fell more than 10% from its peak. In 11 out of 13 such events, the Low Vol strategy outperformed Equity with some of the highest outperformance seen during the 2008 Global Financial Crisis and the 2020 Covid-19 pandemic.
This downside protection helps not only in minimizing notional losses for investors, it also helps in keeping you invested in the markets during turbulent market conditions. This ensures that you stick with your equity investments for longer time frames, improving odds of achieving your financial goals.
- Less pain, more gain – Investment strategies based on Low Vol showcase asymmetry in their return profile. Such strategies tend to outperform by a larger margin in falling markets and they tend to underperform by a far smaller margin in rising markets.
On an average, Low Vol outperforms by 1.9% during months when the market gave negative returns. However, the margin of underperformance was far lower at just 0.8% during months when the market gave positive returns. Therefore, as the market undergoes multiple cycles of bull and bear markets, investment strategies based on Low Vol tend to outperform vs broad-based equity.
In conclusion, investment strategies based on Low Volume aim to buy stocks that have higher price stability. This results in a portfolio of companies with stable earnings visibility, providing good downside protection. Historically, such strategies have also outperformed broad-based equity in markets across the U.S., Europe, and Asia (including India). Therefore, Low Vol based investment strategies can be a great choice for investors that are worried about volatility of equity markets.This article has been issued on the basis of internal data, publicly available information and other sources believed to be reliable.
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