You Take the High Road and I’ll Take the Low Road
That is regarding stock market volatility to be more precise. At Northland Wealth Management, we tend to emphasize the use of equities that exhibit lower volatility than the overall market for many of the families we serve. A low volatility approach has attracted a good deal of interest recently due to the unprecedented fluctuations in global stock markets caused by the financial crisis of 2008. Studies have indicated that over longer periods of time, a low volatility approach to security selection has consistently provided returns which outperform the major market indices. These returns are achieved at a significantly lower “cost” to individual investors in the form of reduced anxiety concerning the safety of their capital. Ultimately, the approach provides a higher degree of certainty for investors to meet their long term investment and retirement goals.
Beta is a measure of risk based on the fluctuation of a stock’s price. The entire stock market is assigned a bet value of 1. Individual stocks with a beta of 2 will fluctuate twice as much as the market. A beta of 0.5 means that the price will move half as much. To maintain diversification, 30- 40 stocks with the lowest betas in the market are selected across all industries to create a low volatility portfolio. The aggregate reduction in volatility of course comes from the characteristics of the individual stocks. These companies represent good value investments based on the traditional measures of price to earnings, book value and cash flow. Lower volatility companies also tend to be in non-cyclical industries and provide stable dividends through differing market cycles. Lastly, the departure from average market weightings in dominant industries such energy or real estate, for Canada is meaningful enough to reduce effects of a market draw down, as was experienced during a crisis like 2008.
The actual reduction in risk is measurable with Canadian and US portfolios varying 25% less than a market weighted portfolio, 30% less in global markets and up to 50% in emerging markets. In a short term market correction and over the life of an investor, these reductions represent real savings in terms of actual capital preservation, and the time required to recover losses in the market. Moreover, there is a beneficial psychological impact to a low volatility approach. Research in the field of behavioral finance has firmly established that individuals assign more weight to a financial loss than a financial gain. In essence, a $50 loss is more painful than the pleasure derived from an equivalent $50 gain. Surprisingly, the bias applies across all investor profiles from conservative to aggressive. This behaviour is captured in the proverbial “Wall of Worry” which clearly shows that investors will benefit in the market over the long term, but the repeated series of advances and reversals along the way is often too much for the individual investor to handle. A low volatility approach to stock selection greatly reduces the effects of market fluctuations, enhancing the value of returns to an investor.
Most investors are familiar with the rule that higher risk equals higher return. A low volatility approach alters this relationship. Research studies have indicated that not only has a low volatility portfolio provided a higher absolute return of between 1-2% on a compound basis, the amount of return generated for the level of risk taken is higher as well. As a result, it may be possible to maintain a higher level of equity exposure in a portfolio in order to benefit from an extended bull market. Additionally, if we follow the lead of institutional investors such as the CPP Investment Board, depending on the particular investment time horizons of a family, it may be prudent to also add exposures to alternative asset classes such as private real estate,hedge funds and private equity, to capture returns from other markets without material changes to an investor’s overall risk profile. The objective is to, through a combination of higher and more consistent returns over market cycles, increase the likelihood a family meet sits broader financial goals over time.
As a summary, stock markets continuously cycle through periods of value and growth, bearish pessimism and bullish optimism. A low volatility approach to equity investing captures the broadest amount of factors underlying returns from the market in a fashion consistent with an investor’s outlook.