Step 1: Focus on Large Cap Stocks
As we discussed in Part 1, the Financial Analyst Journal has stated that the “long-term outperformance of low-risk portfolios is perhaps the greatest anomaly in finance. Large in magnitude, it changes the basic notion of a risk-return trade-off.”2
In addition to the obvious potential for improved returns that this finding implies, there is a very large psychological benefit to traders and active investors. Low volatility stocks usually include many of the largest, most stable companies. We all tend to sleep better at night with positions in Apple and IBM rather than in a start-up biotech “story-stock.”
There is a good reason for this psychological bias towards large cap stocks. A surprising large percentage of companies actually have negative market returns over their entire life. It’s no wonder individual investors are often insomniacs!
The Blackstar Funds report “The Capitalism Distribution” states that:
(1) 39% of stocks had a negative lifetime total return (2 out of every 5 stocks are a money losing investment)
(2) 18.5% of stocks lost at least 75% of their value (Nearly 1 out of every 5 stocks is a really bad investment)
(3) A small minority of stocks significantly outperformed their peers (Capitalism yields a minority of big winners)
The study looked at all of the stocks, current and de-listed, that would have qualified for the Russell 3000 index (i.e. the largest 3000 stocks in the U.S.) from 1983 through 2007. 3
Source: “The Capitalism Distribution” Blackstar Funds report.3 Past performance is no guarantee of future results.
Only one out of five stocks has a significantly positive lifetime return. These are the stocks we want to focus on – at least for our long trades. The companies in this one-fifth of the market are or end up being, more often than not, constituents of the S&P 500 index.
The first step in building a low volatility portfolio is to limit our long trades to companies in the S&P 500. These large cap stocks typically have lower volatility than the broad market (and we’ll filter this list further in Step 2).
These are stocks we can “sleep at night” with. And they allow us to potentially benefit from the low volatility anomaly. Resist the urge to “play the lottery” with penny stocks and micro-cap technology stocks that have a great story and promise to be the next Google. Remember for every Google there are thousands of MySpace, Pets.com, Vonage, and FriendFinders.