Is a low-volatility portfolio the key to investment return?

Open up a book on Investing 101 and it will tell you that a stock’s return will be directly related to its risk. The Investing 101 book states that if you want to have high returns, you have to take on enough risk that ensures if you are wrong, it will end up costing you a good chunk of your portfolio.

When I sit with prospective clients and I ask them about the level of risk they would be comfortable with, they inevitably say they want high returns and little risk. Most financial advisers would answer that you can’t have your cake and eat it. Either you can go for the high returns or the little risk, but there is no way you can have both.

It seems that most financial advisers may be wrong, and the clients may be on to something. Last year there was an article in the Financial Analysts Journal that showed something that flew in the face of conventional financial planning: Over the 41 years ended in 2008, low-risk stocks outperformed high-risk ones.

Keep in mind that if you took a few years, especially years like 2001 or 2008 when the stock market crashed, you could easily make the case that less-volatile stocks would outperform, but in good years that shouldn’t happen. That’s what is so surprising about the research: that in fact over both good and bad markets, the best way to accumulate wealth over the long term was by investing in stocks with low volatility.

This study has been backed up by others. Shannon Zimmerman, an associate director of fund analysis for Morningstar, was recently interviewed by Morningstar.com. When asked about his research that also highlighted the benefits of low portfolio volatility, he said: “That’s true. It does turn out to be the case that over the course of many decades – and sort of building on some research that has been done into individual equities that are rolled up into portfolios – it turns out that less risk, if you define risk as volatility, actually leads to more rewards. There is a low volatility premium akin to the small-cap premium or the value premium that investors are more widely aware of.

“It sort of flies in the face of what people believe, and it seems counter-intuitive. Seemingly, the more risk you take on, the greater the potential reward, and there is a way in which that’s true: The more money you put at stake, if the investment works out, the more you’ll earn. But if you define risk as volatility – and typically academic researchers are defining it in terms of standard deviation or beta – if you look at risk through those lenses, it turns out that the lower beta, the lower standard deviation investments, tend to perform better over the course of many years.”

While that is a bit complicated and technical, Zimmerman is basically saying that stocks that don’t move around much end up performing better than stocks that have more ups and downs.

What’s not love? For clients gun-shy about taking on added risk after a decade that has seen two market routs, this news is a godsend. For most clients, if they can grow their portfolios over time, but don’t have to fret over a monthly statement that shows a huge short-term drop, then all is good.

Zimmerman adds: “So, it turns out that investors use low-volatility funds better because they... don’t get the willies when the quarterly report comes, and they haven’t gone... down 15%... in a flat market. The smoother a ride a fund can give a shareholder, the better they tend to use it.”

And use it they are. A whole slew of new products including ETFs (exchange-traded funds) have hit the market, and they’re all based on the low-volatility strategy. Whether it’s an ETF on the S&P 500, emerging markets or a broad international index, these low-volatility ETFs have seen huge inflows (billions of dollars) of money since their launch.

Investors should speak with their financial professional to see whether low-volatility investments have a place in their portfolio.

aaron@lighthousecapital.co.il Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts.