Buy the Book: The book looks at the persistence of the low-volatility anomaly throughout market history. The author explains why the anomaly exists and how to construct a portfolio of low-volatility stocks to take advantage of it.
The Notes
- One of the biggest investing paradoxes is that low-risk stocks produce high returns while high-risk stocks produce low returns (academic finance assumes risk = volatility, and that investors must take more risk to earn more return. The low volatility anomaly refutes that assumption).
- “Simplifying is quite difficult; it’s much easier to make things complicated.”
- The author’s lessons from his earliest investment:
- Don’t be overconfident.
- The power of compounding can work for you and against you.
- High-risk stocks aka highly volatile stocks are not guaranteed to earn a high return — they can lose a lot.
- Volatility is a standardized measure of an investment’s price fluctuations.
- “Volatility is quite persistent over time. In other words, a stock that displays a low degree of volatility will probably also remain a low-volatility stock in the future. The same applies to high-volatility stocks.”
- The author’s low volatility study:
- Started with the 1,000 largest U.S. companies by market cap.
- Excluded stocks trading less than $1 per share.
- Ranked companies by their monthly return volatility over the past 3 years.
- Created 2 portfolios: 100 lowest volatile stocks and 100 highest volatile stocks (rebalanced quarterly).
- Backtested from 1929 to 2015.
- 100 lowest volatile stocks: 10.2% annual return with 13% annualized volatility.
- 100 highest volatile stocks: 6.4% annual return with 36% annualized volatility.
- Low vol stocks won by losing less than high vol stocks.
- Backtested from 1932 to 2015, low vol still wins. Low vol stocks were still ahead despite avoiding the worst drawdowns suffered by high-vol stocks following the 1929 crash (the US stock market bottomed in 1932).
- Breaking the 1,000 stocks into 10 deciles ranked highest to lowest, the highest vol decile produced the worst returns but the lowest vol decile does not produce the best returns. The 2nd-lowest decile outperformed the 1st, earning an 11.6% annual return. The 3rd lowest outperformed the 1st decline too — 11.5% annual return. The 1st decline only outperformed the 9th and 10th deciles (the two highest vol deciles) — suggests low vol is a good option to combine with other anomalies.
- Taking some additional risk increases the average return, but too much risk leads to low returns.
- “Taleb is skeptical of relying too heavily on statistical risk measures, such as volatility, and relates this to the financial crisis. He is probably right: too much reliance on statistical risk measures can cause more harm than good.”
- “Volatility is the degree of price variation. As a rule of thumb, 20% is the average annual volatility of an average stock. A typical stock has a 1/3 chance of going up or down by more than 20% in the course of a year and has a 2/3 chance of staying within this 20% bandwidth.”
- Simple vs Compound Returns: simple returns are an average while the compound return is the geometric average. Ex: If you lose 50% one month and then gain 50% the next, the simple return is 0% but you actually lose 25% (the compound return is a 25% loss).
- Robert Haugen was the first to discover the low-vol anomaly in 1975.
- Many Definitions of Risk:
- Risk is volatility (academic finance)
- Risk is underperforming (deviating from) a benchmark (relative risk and career risk). Too much relative risk is a career ender.
- Risk is losing money (absolute risk or common sense)
- Low-vol portfolios make sense if limiting downside risk (drawdowns) is the goal.
- Behavior that Hurts Returns:
- Investors have an unhealthy tendency to compare their returns to others.
- Eric Falkenstein argues that a focus on relative risk stimulates investor envy and negatively affects decisions.
- Investors tend to invest in stocks they find attractive — fad stocks, headline stocks, lottery stocks, high-risk stocks.
- Behavior that Helps Returns:
- Ignore the urge the compare returns with others.
- Focus on absolute returns and long-term portfolio growth.
- Remember the advantage of compounding over the long run.
- Be patient!
- Low-vol stocks tend to be overlooked because they are boring companies and carry high relative risk.
- “Elroy Dimson estimates that about half of the total return generated by the US and UK stock markets between the years 1900 and 2000 was attributable to dividends.”
- The Conservative Portfolio:
- The author combines low-vol with shareholder yield and momentum.
- Shareholder yield: dividend yield plus buyback yield — higher is better.
- Momentum: stocks with a positive price trend — helps avoid value traps.
- The Strategy:
- Started with the 1,000 largest U.S. stocks by market cap.
- Calculated the volatility (same as above) and excluded the 500 most volatile.
- Ranked the remaining 500 stocks on shareholder yield and 12-month momentum. Each stock gets a score (1-500) for both factors, which are combined, and stocks are reranked on the combined score.
- The top stocks should be low-vol, high shareholder yield, and positive momentum.
- Buy the top 100 ranked stocks.
- Backtested from 1929 to 2015.
- Produced a 15% annual return, outpacing the lowest-vol decile stocks, high-risk stocks, and S&P 500 (by 4%). It even outperformed high-risk stocks every decade from the 1930s to the 2010s.
- Beta: measures volatility relative to the market. The “market” has a beta of 1. A stock with a beta greater than 1 is more volatile than the market. A stock with a beta less than 1 is less volatile than the market.
- “The investment paradox also exists when stocks are sorted based on beta, although the results are slightly stronger when stocks are sorted on volatility.”
- Tip: Set up Google Alerts for news on stocks or funds you own.
- Overtrading
- “The level of annual stock turnover has been above 100% since the 1990s, after decades of low turnover from the 1940s to the 1970s. Current turnover levels imply that, on average, investors hold on to a stock for less than one year.”
- High turnover, leads to higher costs, which eat into returns.
- Overconfidence leads to overtrading.
- “Women trade less than men, which leads to lower trading costs and higher after-cost returns.”
- “Martijn Cremers found that the most patient — and moderately active — mutual fund managers are able to outperform their peers and benchmarks by some 2% per year.”
- Low Vol Performance in Different Market Cycle Scenarios:
- Bear Market (< 0% returns): Low-vol stocks tend to lose less vs. the market. Low-vol portfolio suffered a 5.4% loss, on average, versus a 16.1% loss for the market during bear markets.
- Mild Bull Market (< 15% returns): Low-vol stocks tend to perform as good or slightly better than the market.
- Strong Bull Market (> 15% returns): Low-vol stocks tend to underperform the market.
- The key is to stay invested while underperforming during the most bullish markets.
- Historically: “The risk of losing money on the stock market in any given year is about 30%, falling to 10% for a five-year horizon… When you invest in conservative stocks, the risk of losing money on a one-year basis is lower: only 20%, and this falls to just 1% on a five-year basis.”
- “The stock market is driven by people and their emotions and their desire to compare. Interestingly, this fact of life creates opportunities for those who can control their ‘passions’ and ‘animal spirits’ and show virtue.”
- Stocks with high debt levels tend to underperform the market average.
- Stocks with a high chance of financial distress (default or bankruptcy), tend to underperform the market average.
- Low Vol Everywhere:
- Studies show that the low-vol anomaly exists in international and emerging markets.
- Studies show that less volatile international stock markets offer better returns than more volatile stock markets.
- Defensive sectors (less volatile) outperform cyclical sectors (more volatile).
- Less volatile corporate bonds perform better than high volatile bonds.
- Less volatile commodities perform better than high volatile commodities.
- Less volatile options perform better than high volatile options.
- “Risk is not bad in all cases, but please be aware that it is not rewarded in almost all cases. As a rule of thumb, avoid anything that looks like a lottery ticket or promises you a very high return. Do not place long-shot bets, not at the horse track and not in your investment portfolio.”
- “This existence of a positive bond premium and equity premium suggests that investors are risk averse in the asset allocation decision phase (phase I), but change behavior when they select securities within these markets (phase II).”
- “There isn’t one single best investment method. Yes, it is best to avoid high-risk stocks if possible. And income and momentum strategies also give good results. However, instead of focusing on one, you probably will be happier (and wealthier!) if you just maintain a broader perspective and avoid extremes.”
