Greater risk, greater reward. We’ve all heard that before.
But is it really true?
Or can a low volatility portfolio actually bring better, steadier returns?
In one of our last articles, we’ve already talked about how important it is to diversify your portfolio in order to avoid putting all your investment eggs in one basket and therefore reduce your risks.
Today, let’s talk about portfolio volatility: what it is, why it matters, and how it can help you mitigate risks.
The Speed Read:
1. Volatility is used as a measure of risk.
2. Volatility is driven by a number of factors, from the state of the economy to human psychology.
3. High volatility often implies bigger risks.
4. While low volatility traditionally means less risks, less returns, it is not always the case.
What is volatility?
Before we dive into the benefits of a low volatility portfolio, you may ask yourself: what is volatility?
In investment terms, the volatility of a stock’s market price is a measure of how widely the price actually fluctuates.
A volatile market is characterised by wide fluctuations in the price and often large volumes of trading, as people rush to sell stocks in a panic, or buy stocks on good news or out of fear of missing out.
Volatility is also often used as a measure of risk. If a stock is very volatile, you can expect large swings in its price and therefore a higher chance of making or losing money. In layman terms, the higher the volatility, the more of an emotional rollercoaster journey investors may experience.
Means that a security’s value does not fluctuate dramatically and tends to be more steady.
Means that a security’s value can change dramatically over a short period of time in either direction.
What causes volatility?
Volatility is driven by a number of factors, from the state of the economy to human psychology.
If the current economic and political situation is calm and there isn’t much uncertainty about the near future, most information will be priced into the stock market, making stocks less volatile. Meaning, in other words, that stocks won’t move about too much since people don’t expect too many things to change.
There have been long periods of time when volatility remained low. Then, however, there are also times like the 2008 financial crisis or the 2020 unexpected arrival of the coronavirus pandemic that can cause high levels of uncertainty and result in so-called volatility spikes.
Volatility itself is actually traded in the market in the form of financial instruments called options. Options tell us about the market's expectation of volatility, which are called ‘implied (or expected) volatility’. There are options on stocks, indices (e.g. S&P 500, Euro Stoxx 50 or FTSE 100), or foreign currencies, commodities and even on interest rates.
To get an idea of how much volatility can change in times of panic, have a look at the VIX volatility index below from just before the 2008 financial crises up until November 2020:
The VIX index essentially measures the market’s expectation of volatility for the 500 largest stocks in the US (so, based on S&P 500 index options). As you can see, the volatility was relatively low most of the time. However, during times of heightened uncertainty, market participants can panic and sell stocks in large volumes causing prices to fall sharply and rapidly, thus causing volatility to jump.
It is mainly economic uncertainty and human psychology that cause market volatility to increase, although some trading algorithms have also been occasionally blamed for it.
Relevant read: Volatility: how ‘algos’ changed the rhythm of the market
The uncertainty aspect could be due to upcoming elections, trade negotiations, consumer confidence, differences between expected and actual earnings announcements of companies, unforeseen events (like an earthquake or global pandemic), or even media speculations.
Is high or low volatility better?
So what is better: buying low volatility or high volatility stocks? Having a low volatility or high volatility portfolio?
When answering this question, you need to remember that when it comes to low volatility stocks, the expectation of a quick return is lower since you do not expect to have as large swings in the price. Then again, unless you’re trading, i.e. quickly buying and selling stocks to book immediate profits, adopting a long-term investment mentality isn’t the worst thing to do 😉.
If you invest in low volatility stocks, you might not be as exposed to a few big winners over the short term. However, you also avoid an emotional roller coaster along the way and are better able to prevent a substantial loss of money caused by some high-risk stocks that can’t recover and that can damage your portfolio beyond repair.
You have to remember that any time you need to recover from a loss in your portfolio, you always need to bring in bigger returns.
This happens because, when calculating your return percentages, the calculation always goes from the starting point to the ending point, with the starting value as the base. So, for example, if you invested €100 and your investment went up 10%, it’ll be worth €110. However, a drop of 10% would put the investment at €90, so, after this loss, your new starting point would be €90. Yet, remember that your starting value was originally €100, not €90. To get back to where you started from, you’d need to make up for the loss and take a €10 gain to get back to the original €100. 10 divided by 90 shows, in this case, that you would need a 11.1% gain to recover from the loss.
The bigger the loss, the harder it is to recoup! That’s because the return necessary to recover in order to break even increases at a much faster rate:
- If a stock loses 10%, it has to gain 11.1% to get back to even
- If a stock loses 25%, it has to gain 33% to get back to even
- If a stock loses 50%, it has to gain 100% to get back to even
- If a stock loses 80%, it has to gain 500% to get back to even
Thus, you could potentially do more damage to your portfolio with a high-volatility stock that experienced a significant loss, because it puts pressure on all the other stocks in your portfolio not just to make up for that loss, but significantly outperform it.
Does a low volatility portfolio outperform?
The usual mantra is that the higher the volatility (i.e. risk), the higher the expected returns. If you take more risk, you expect to be rewarded more, right?
Recent research (e.g. here and here) has shown an anomaly that, in fact, lower volatility stocks have been constantly outperforming higher volatility stocks across most markets. Yes, you read it right: lower risk and higher return. This even has a term of its own: Low Volatility Anomaly.
Low Volatility Anomaly:
The observation that low volatility stocks have higher returns than high volatility stocks in most markets studies. This is an example of a stock market anomaly since it contradicts the usual prediction that higher risk always equals higher returns.
How is that possible?
One of the many explanations is, for example, that many investors like lottery-like payouts and buy higher volatility attention-grabbing stocks often overpaying for them. These investors could have performed better by buying less volatile yet more “boring” stocks at better prices. Remember the story of the tortoise and the hare? It’s a similar thing. (Spoiler Alert: the slow and steady tortoise wins in the end.)
But wait a minute: does all of this mean that a low volatility portfolio has no high volatility stocks?
Not at all!
If you put two or more volatile stocks together, you don’t necessarily get a higher volatility portfolio — in fact, you often reduce the portfolio volatility instead. If this sounds counterintuitive, it is only until you realise that, in a portfolio, everything is dictated by correlation, i.e. the degree to which stocks move together.
A statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management.
Let’s say, you have two volatile stocks and they tend to move into opposite directions. If you add them together in a portfolio, the overall volatility of the portfolio will reduce, as the gain on one stock will partially offset the loss on the other.
This is the logic behind portfolio diversification. Add asset class (stocks, bonds, real estate, etc.), sector (technology, renewables, healthcare, sustainable consumption, etc.), geographic, demographic and other diversifying factors, and you have a nice recipe for a well-diversified portfolio. Obviously, just randomly mixing all the ingredients together isn’t going to give you a lovely cake, there is a science and art to this known as portfolio management.
Here is, for example, how it’s done at Cooler Future.
At Cooler Future, we construct our portfolio in such a way that we try to minimise volatility while maximising return.
As you’ve already learned, looking at either risk or return individually doesn’t make much sense — so we look at the problem through a risk-return lens, also called risk-adjusted return.
Diversity is, of course, a major component of the strategy too, and we supplement that with a forward-looking approach both in terms of market & credit risk, as well as climate risk. Our aim is to support the climate transition, i.e. the move to a net-zero carbon emissions world. While we do that, we try to avoid those companies, e.g. oil and gas companies, coal miners etc., whose business strategies do not align with our community’s values. That’s because we expect these companies, while they continue to be extremely volatile, to also underperform in the long run. Instead, we focus on those companies that are taking climate change seriously and are the future climate winners — and could benefit the portfolio and the planet as a result.
Such companies are thinking about a long term sustainable future and are often hidden gems that yield good returns while maintaining relatively low volatility.
So — greater risk, greater reward? Apparently not quite so.
Now that there’s a mounting body of evidence proving the opposite, it is clear that keeping your portfolio volatility low can actually generate higher returns in the long run. A job of any investor, at the end of the day, is to be able to protect the portfolio against big losses, mitigate portfolio risks, and get the right combination of assets that, altogether, reduce portfolio volatility and deliver safe and steady returns.