Low Volatility Stock Investing

Investing in low volatility stocks may help improve your risk-adjusted returns.

Enhance Your Risk-Adjusted Returns with Low Volatility Stocks

Typically in investing, the more risk an investor takes on, the higher their possible reward. This risk-reward trade-off sits at the heart of financial markets. But this trade-off doesn’t apply to all types of stocks. Low volatility stocks flip the risk-reward tradeoff upside down. Long-term data has shown that stocks that are less volatile than the market offer investors equal to or slightly better returns. As a result, the risk-adjusted returns of low volatility stocks are superior to that of the overall market.

Stocks that are less volatile than the market tend to be attractive to conservative equity investors who are looking for growth but also want stocks that decline less than your average stocks during corrections and bear markets. The fact that they are less risky is one of the keys behind why low volatility stock investing works. Investors bid up the price of risky stocks, treating them like “lottery tickets,” while systematically underpricing low risk stocks. When the high-risk stocks decline, they decline more than lower risk stocks.

Take the following example: If a stock declines from $100 to $80, that is a 20% loss, but to get back to $100 the stock needs to achieve a 25% return. Because low volatility stocks typically decline less than the market, they have the ability to recover losses more quickly.

Next, we’ll look at how to define low volatility, where low volatility stocks can be found and some of the considerations when investing in low volatility names.

The Long-Term Appeal of Low Volatility Stocks

Low volatility stocks can be found in any segment of the market, but the most common sectors include Utilities, Real Estate and Consumer Staples. Many of these companies pay out healthy dividend yields, so it’s important to point out that both the level and direction of interest rates can play a role in investors’ appetite for low volatility stocks. When interest rates are low and falling, it makes conservative stocks with high dividends appealing and seen as a possible alternative to long-term bonds (and vice versa if rates are high and increasing).

Research has shown that a basket of low volatility stocks can outperform the broader stock market and do so with less risk over the long-term. The outperformance of low volatility stocks was most pronounced in down years for the market or during major market declines such as the bear market periods from late-2000 to late-2002 or mid-2007 to early-2009. During these types of downturns, equity investors look for stocks that are considered more conservative and able to better weather difficult market environments.

How to Measure Volatility in Stocks

Although low volatility stocks may have certain common fundamental characteristics, the way low volatility securities are identified has little to do with analyzing a company’s financial situation or valuation. Instead, a stock’s volatility is derived by looking at the past price performance and determining if it displayed more or less risk than the market (investors may also look at stocks on an intra-sector or intra-industry level for comparison purposes).

There are two common metrics for determining a stock’s volatility:

Beta: This looks at a stock’s risk relative to the overall market. Beta takes into consideration both the risk and correlation. The market carries a beta of 1.0, so stocks with betas’ of less than 1.0 are considered less risky and therefore, lower volatility type stocks. Learn more about Beta
Standard Deviation: This is a measure of standalone risk, and investors can use this to compare and rank stocks to help isolate low volatility stocks. Learn more about Standard Deviation

Low volatility investing may also be augmented by incorporating other investment factors. For example, filtering for low volatility stocks and then looking at additional metrics like shareholder yield (dividend yield, share buyback yield and debt paydown yield) and momentum has shown to be effective based on research.

Finding Low Volatility Stocks in Today’s Market

Investors who are looking for stocks that have the ability to produce solid long-term results, but that are less risky may consider screening for low volatility stocks. Volatility can be used in isolation or combined with other fundamental measures of value. By incorporating low volatility stocks into an equity portfolio, investors can limit risk and losses.

Everyday, we identify the top scoring low volatility stocks in the market by scoring and ranking based on volatility in two ways. We rank based on Standard Deviation, which measures the volatility of each stock on a standalone basis. We also rank on Beta, which accounts for a stock’s correlation with other stocks. We then use a composite score that combines both a stock’s Standard Deviation and Beta metrics.

Stocks that score high tend to be larger, more established companies in the market with long histories of being in their businesses and paying dividends.

See the Top Scoring Low Volatility Stocks in Today’s Market

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