In the Part 1 of this series we discussed the evidence that has come to light over the past 40 years that shows us that low volatility stocks out-perform high volatility stocks. Contrary to the financial theories taught to every MBA student, investors do not get paid for taking on more risk.
Source: “Low Risk Stocks Outperform within All Observable Markets of the World” (Baker and Haugen, 2012) and lowvolatilitystocks.com. Study of 2997 U.S stocks and 9494 stocks from 21 developed countries; Risk is defined as standard deviation over previous 24 months.1 Past performance is no guarantee of future results.
This is called the “low volatility anomaly” in the academic world. Traders and active investors can utilize this research to build more effective and potentially lower risk portfolios.
Over the past 9 years LCA Capital and its affiliate company, Connors Research, have developed a unique methodology for creating active, low volatility portfolios.
The 7 Step Low Volatility Investing Method:
(1) Focus primarily on large cap stocks
(2) Buy stocks with low volatility; and, if appropriate, sell short stocks with high volatility
(3) Diversify portfolios by using strategies with different hold periods (time horizons)
(4) Buy high momentum stocks for longer hold periods
(5) Buy stocks that are under-priced and sell short stocks that are over-priced when holding positions for shorter time periods
(6) Go to cash and/or increase short allocations in adverse market environments (i.e. use a market timing overlay)
(7) Hedge strategies with higher than desired volatility
This article discusses the first 2 steps necessary to build a successful low volatility portfolio.