Low volatility: Meaning, Criticisms & Real-World Uses

What Is Low Volatility?

Low volatility refers to the characteristic of an investment, typically a stock or a portfolio of stocks, that exhibits less price fluctuation over a given period compared to the broader market or other investments. In the realm of portfolio theory, a low volatility asset is one whose returns deviate less from its average return, indicating a more stable and predictable performance. Investors often consider low volatility strategies as a defensive approach to building an investment portfolio, aiming to reduce overall portfolio risk and potentially achieve higher risk-adjusted returns over the long term. This approach stands in contrast to the traditional notion that higher risk is always rewarded with proportionally higher returns.

History and Origin

The concept of low volatility as an investment factor gained significant attention through the observation of what is often called the "low volatility anomaly." This anomaly challenges a core tenet of classical finance theory, specifically the Capital Asset Pricing Model (CAPM), which posits a positive and linear relationship between risk (measured by beta) and expected return.

Academic research began to identify this phenomenon in the early 1970s. Early studies by financial theorists such as Fischer Black, Michael C. Jensen, and Myron Scholes, and independently by Robert Haugen and James Heins, provided empirical evidence that stocks with lower levels of volatility or beta often delivered comparable or even superior risk-adjusted returns compared to more volatile stocks¹¹, ¹². For instance, a 1972 study by Haugen and Heins indicated that low-beta stocks in the United States outperformed during a significant period from 1929 to 1971¹⁰. This counter-intuitive finding laid the groundwork for further research into why low volatility investments seemed to defy conventional wisdom, making it one of the most robust and persistent market anomalies observed over decades and across various markets⁸, ⁹. The prominence of low volatility strategies grew, particularly after the 2008 Global Financial Crisis, as investors sought more stable investment experiences⁷.

Key Takeaways

Low volatility investments are characterized by smaller price fluctuations compared to the overall market.
The "low volatility anomaly" suggests that these less volatile assets have historically generated competitive or even superior risk-adjusted returns over the long term, challenging traditional finance theories.
Low volatility strategies are often considered defensive, aiming to provide downside protection during market downturns.
The persistence of the low volatility anomaly is attributed to various factors, including investor behavioral biases and institutional constraints.
Investors can gain exposure to low volatility through individual securities selection, mutual funds, or exchange-traded funds (ETFs) that specifically target this factor.

Formula and Calculation

Low volatility, in a quantitative sense, is typically measured using the standard deviation of an asset's historical returns. Standard deviation quantifies the dispersion of returns around the average return, with a lower standard deviation indicating lower volatility.

The formula for standard deviation ($\sigma$) of a series of returns ($R_i$) over $N$ periods is:

\sigma = \sqrt{\frac{\sum_{i=1}^{N} (R_i - \bar{R})^2}{N-1}}

Where:

$R_i$ = individual return in period $i$
$\bar{R}$ = the average (mean) return over the periods
$N$ = the number of periods

To identify low volatility assets, an investor or manager would calculate the historical standard deviation for a universe of securities and then select those with the lowest values. This quantitative approach forms the basis for constructing low volatility portfolios.

Interpreting Low Volatility

Interpreting low volatility involves understanding its implications for an investment portfolio and broader market dynamics. A low volatility investment is typically seen as a way to reduce portfolio risk. During periods of market stress or downturns, assets with low volatility tend to experience smaller drawdowns compared to the overall equity market, offering a degree of stability. This characteristic makes them appealing for investors focused on capital preservation or those with a shorter investment horizon for a portion of their assets.

From a performance perspective, the "low volatility anomaly" suggests that these assets not only offer reduced risk but have historically achieved favorable returns, often outperforming higher-risk counterparts on a risk-adjusted basis⁶. This implies that simply taking on more risk does not necessarily translate into proportionally higher returns. Therefore, interpreting low volatility involves considering both its risk-mitigating properties and its potential to enhance Sharpe Ratio and overall portfolio efficiency, aligning with principles of robust risk management.

Hypothetical Example

Consider an investor, Sarah, who has two hypothetical portfolios: Portfolio A, a low volatility portfolio, and Portfolio B, a general market portfolio. Both portfolios start with an initial value of $100,000.

Scenario 1: Market Downturn
In a severe market downturn, the general market portfolio (Portfolio B) might fall by 20%, resulting in a value of $80,000. In contrast, the low volatility portfolio (Portfolio A), due to its defensive characteristics, might only decline by 10%, retaining a value of $90,000. Sarah's low volatility portfolio helped mitigate the impact of the drawdowns.

Scenario 2: Market Rebound
Following the downturn, the equity market experiences a strong rebound. Portfolio B (general market) rises by 25% from its depressed value ($80,000 * 1.25 = $100,000). Portfolio A (low volatility) might rise by 15% from its less depressed value ($90,000 * 1.15 = $103,500).

Even though Portfolio A's rebound percentage was lower, its smaller initial decline meant it had less ground to recover. In this hypothetical scenario, after the full cycle, Portfolio A ($103,500) has outperformed Portfolio B ($100,000) while experiencing significantly less fluctuation. This illustrates how managing downside risk through low volatility can contribute to better long-term outcomes for an investment portfolio.

Practical Applications

Low volatility investing has become a significant component of modern asset allocation and factor investing strategies. Investors can apply low volatility principles in several ways:

Defensive Core Holdings: Many investors use low volatility funds as a core component of their investment portfolio to provide a more stable foundation. These funds are designed to perform relatively well during market downturns, offering a degree of risk management and reducing overall portfolio drawdowns.
Exchange-Traded Funds (ETFs) and Mutual Funds: A growing number of ETFs and mutual funds are specifically designed to track low volatility indices or implement low volatility strategies. For instance, the S&P 500 Low Volatility Index screens for and weights the 100 least volatile stocks from the S&P 500, offering a benchmark for such strategies⁵. These products allow retail and institutional investors to easily gain exposure to this factor.
Portfolio Diversification: Incorporating low volatility assets can enhance overall diversification by introducing a factor that behaves differently from traditional market-capitalization-weighted indices, potentially improving the portfolio's Sharpe Ratio.
Institutional Asset Management: Large institutional investors, such as pension funds and endowments, increasingly integrate low volatility strategies to manage risk and achieve consistent returns, particularly given their long-term investment horizons and liability-matching objectives.

Limitations and Criticisms

Despite the historical outperformance associated with the low volatility anomaly, these strategies are not without limitations or criticisms. One common critique revolves around their potential for underperformance during strong bull markets. Since low volatility assets are inherently less sensitive to broad market movements, they may lag behind market-cap-weighted indices when high-beta, growth-oriented stocks are leading the rally. This can lead to periods of relative underperformance, which some investors might find challenging.

Another point of discussion concerns the explanations for the anomaly's persistence. While some academic theories point to behavioral biases, such as investors' irrational preference for high-risk, "lottery-ticket" stocks or institutional constraints (like mandates preventing the use of leverage to boost returns from low-risk assets), others suggest that the anomaly might be slowly arbitraged away as more capital flows into these strategies², ³, ⁴. However, the anomaly has shown remarkable resilience over many decades and across various asset classes and geographies, suggesting that pure arbitrage might be limited due to market frictions or other structural reasons¹.

Furthermore, defining and measuring "low volatility" can vary, leading to different portfolio constructions and potentially different outcomes. While historical standard deviation is common, other measures of risk could be used, and the look-back period for calculating volatility can also influence stock selection. These nuances mean that not all "low volatility" products will perform identically, and investors need to understand the methodology behind their chosen investment.

Low Volatility vs. Beta

While often discussed in similar contexts related to risk, low volatility and beta represent distinct concepts in finance.

Low volatility refers to the overall price fluctuations of an asset, typically measured by its historical standard deviation of returns. An asset with low volatility exhibits less erratic price movements regardless of whether those movements are correlated with the broader market. It's a measure of total risk.

Beta, on the other hand, measures an asset's systematic risk, or its sensitivity to the movements of the overall market. A beta of 1 indicates the asset moves in line with the market, a beta greater than 1 suggests higher sensitivity (more volatile than the market), and a beta less than 1 suggests lower sensitivity (less volatile than the market). The Capital Asset Pricing Model (CAPM) primarily uses beta to explain expected returns.

The confusion between the two often arises because assets with low beta tend to also exhibit low overall volatility. However, it's possible for an asset to have low total volatility but still have a relatively high beta if its less frequent movements are strongly correlated with the market. Conversely, an asset could have moderate total volatility but a low beta if its movements are largely idiosyncratic (specific to the company) rather than market-driven. The "low volatility anomaly" suggests that strategies focused on stocks with low total volatility have outperformed, which also implicitly captures the outperformance of low-beta stocks, but the two measures are not interchangeable.

FAQs

What does "low volatility" mean in investing?

In investing, "low volatility" refers to investments, usually stocks or funds, that show smaller price swings or fluctuations over time compared to the broader market. These investments are considered more stable and predictable.

Why would I want low volatility investments in my portfolio?

Investors often seek low volatility investments to reduce overall portfolio risk and potentially experience smaller losses during market downturns. Historically, these investments have also shown a tendency to deliver competitive risk-adjusted returns over the long term, making them attractive for long-term investors or those sensitive to large market swings.

Is low volatility the same as low risk?

Low volatility directly relates to price stability, which is a component of risk. While often associated with lower overall risk, it specifically measures the degree of price fluctuation. Other types of risk, like liquidity risk or credit risk, are not directly captured by volatility measures.

Do low volatility strategies always outperform?

No. While low volatility strategies have demonstrated a historical tendency to achieve competitive returns on a risk-adjusted basis, especially during bear markets, they may underperform during strong bull markets when more aggressive, high-growth stocks are leading market gains. Investment performance is not guaranteed, and past performance is not indicative of future results.

How can I invest in low volatility?

You can invest in low volatility through individual stock selection, by choosing companies with historically stable earnings and stock prices, or more commonly, through specialized investment products. These include factor investing ETFs and mutual funds that are specifically designed to track indices or employ strategies focused on low volatility stocks, offering a convenient way to add this factor to your diversification efforts.