One of the first things you learn in a college-level finance class is that a “rational” investor should get rewarded for taking on more risk.
After all, why would an investor accept higher risk if they aren’t going to get compensated for it?
This assumption comes from the original academic pricing model for securities – the Capital Asset Pricing Model (CAPM).
In this issue of the Connors Research Traders Journal, we’re going to see that the opposite is true. Volatility Hurts!
The Low Volatility Factor Is Real
The low volatility factor is the empirical reality that “defensive” stocks (lower-volatility, lower-risk) have delivered higher risk-adjusted returns compared to “aggressive” stocks (higher-volatility, higher-risk).
This is a large blow to CAPM.
CAPM states that there is a positive relationship between risk and return, as a “rational” investor should demand a higher return to compensate for accepting more risk.
Not only does this fail to hold up in the real world, but the empirical results are the opposite.
First, The Academic Support
Academic evidence for the low volatility premium is robust and includes the 2016 study “Understanding Defensive Equity” written by Robert Novy-Marx.
Novy-Marx ranked stocks by quintiles of either volatility or market beta and showed that the most volatile/highest beta quintile dramatically underperformed the rest of the stocks.
Here is a link to the paper below:
Further evidence is provided by Andrea Frazzini and Lasse Heje Pedersen in their 2014 paper “Betting Against Beta.”
The professors formed portfolios that went long low beta stocks (leveraged to a beta of 1) and shorted high-beta stocks (deleveraged to a beta of 1). This market neutral portfolio realized a Sharpe ratio of 0.78 from 1926 to 2012.
Frazzini and Pedersen then expanded this research to not only include the US but investigated 10 international equity markets and found similar results.
Here is their paper…
Here Are The Connors Research Findings
To quantify the low volatility factor, we formed two long-only portfolios containing the 50 stocks with the highest and lowest historical volatility.
These portfolios are rebalanced monthly.
Our lookback window to calculate volatility is 100 days.
These tests run from 01/01/2003 to 02/18/2020, over 17 years of data.
Our universe is the Q500US universe containing the 500 most liquid US Stocks.
Here are the historical test results:
As can clearly be seen, low volatility stocks have handily outperformed high volatility stocks in this test.
Low volatility stocks:
- Produced higher returns: 10.07% vs 4.99%
- Had nearly half the max drawdown: -39.98% vs -74.77%
- Resulted in a Sharpe Ratio of nearly triple: 0.90 vs 0.31
- Showed Alpha of 4% and a Beta of 0.57
Use Low Volatility To Your Advantage Especially with Quantamental Strategies
The data clearly shows the advantage of investing in low volatility stocks. They produce consistently higher risk-adjusted returns and less risk overall.
The addition of this factor can help improve existing trading strategies, especially as you combine them with fundamental analysis along with technical analysis as we teach in our Quantamentals Course. We’ve seen this one factor alone significantly improve the results greater than many other solid indicators and factors.
You can learn more about Quantamentals and how it can improve your investment results by attending our free webinar on February 26. Click here to register now.
High volatility may be “exciting” to trade but when it comes to investing it’s significantly better to be in lower-volatility companies. Lower volatility stocks tend to be safer, more predictable, and as you can see from the studies above, historically you’ve been far greater rewarded.
Upcoming Online Events From Connors Research and TradingMarkets
We’d like to invite you to a free class teaching you how to use the Quantopian platform, taught by Chris Cain, CMT.
If you’re interested in learning how to use the Quantopian platform to create strategies, run backtests, and get daily signals, we’re conducting a free live 90-minute class on Tuesday, February 25 at 1 pm ET.
In this introductory class, you’ll be on the Quantopian platform and Chris will teach you how the platform works.
Chris will also be sharing with you a simple strategy and the strategy code, which you will paste in to run the test results. You’ll also see the full analysis of the backtesting results Quantopian offers, along with how Quantopian generates signals.
This class is for anyone who hasn’t been on Quantopian and wants to learn about what Quantopian can do for your trading.
We’d like to invite you to a free 45-minute webinar we’ll be conducting with Chris Cain, CMT, this Wednesday, February 26 at 2:00 pm ET on Quantamentals; The New Forefront of Trading and Investing.
In the webinar, we will teach you…
- What are Quantamentals and why it’s amongst the fastest growing areas in trading and investing
- How to combine Technical Analysis with Fundamental Analysis and Quantitative Analysis with the objective of seeking superior returns
- Which indicators are amongst the best to combine. This will be of special interest to you if you’ve ever thought of combining fundamental analysis with your technical analysis
Plus, we’ll share with you details for an upcoming course we’ll be teaching in March which will provide you with the in-depth knowledge to apply Quantamentals to your trading and investing.
There is no cost to attend the webinar. Whether or not you’re already applying Quantamentals to your trading there will be new information presented to help you improve your trading and investment returns.
It is time for our monthly 45-minute webinar on The Alpha Formula, where we will discuss where we see Alpha in the marketplace today and which strategies you should use to use to capture these excess returns.
If you have not yet ordered a copy of The Alpha Formula – Beat the Market with Significantly Less Risk, you can do so by clicking on this link: https://tradingmarkets.com/alphaformula.
If you’d like to join us live on Thursday, February 27 at 1 pm ET, please click here to register now.
This monthly event is limited to buyers of The Alpha Formula. To order your copy please click here now.
If you have any questions about any of the upcoming free events, please call or email Tim Kiggins at 973-494-7311 ext. 616 (firstname.lastname@example.org)
Larry Connors and Chris Cain, CMT