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With Securities, Risk Does Not Always Produce Reward

Finance 101: Accept more volatility and you’ll be rewarded over time. But for individual securities, this is does not hold up. Why?

This blog is part of a new series on Institutional Investor entitled Global Market Thought Leaders , a platform that provides analysis, commentary, and insight into the global markets and economy from the researchers and risk takers at premier financial institutions. Our first contributor in this new section of Institutionalinvestor.com is AllianceBernstein, who will be providing analysis and insight into equities.
 

The first lesson of Finance 101 is that risk and return go hand in hand: accept more volatility and you’ll be paid with higher rewards over time. With regard to asset classes—comparing stocks with bonds, for example — this basic precept of investing holds up quite well. But with regard to individual securities, it doesn’t hold up. Our research shows that low-volatility stocks — as measured by standard deviation or any other commonly used proxy — have historically been associated with higher long-term returns, and we see no reason for this relationship to change going forward. How can this be?

Rooted in Behavioral Finance

As we all know, the markets are inefficient, often due to enduring patterns of investor behavior. For example, fear propels many investors to abandon stocks with low price-to-book-value ratios, leading those stocks tend to deliver superior returns over the long term. Yet at the same time, a “lottery” mentality often drives many investors to buy highly volatile stocks—stocks that can readily lose big as well as win big, dragging down their performance over the long term.

No stock should be regarded as a low-risk asset, as the market is demonstrating dramatically today—but everything is relative. Indeed, stocks with lower volatility than the market tend to outperform over the long term (Display). The fundamental reason, it appears, is that low-volatility stocks as a group offer higher dividends and generate strong cash flows, which supports their valuations in down or “crisis” markets. When global markets plummeted more than 10% in early August, low-volatility strategies declined by much less. By outperforming in down markets, low-volatility stocks are able to deliver strong returns with low volatility over full market cycles.

A Strategic Perspective on Low Volatility

The low-volatility anomaly cuts across global geographic boundaries and spans the value/growth divide. That’s why low-volatility stocks may or may not be particularly cheap (many aren’t right now), and why they may or may not have high earnings-growth potential. But by earmarking a portion of an equity allocation to lower-volatility stocks, investors implicitly open up the remainder of their stock portfolios to higher-volatility securities, giving them the prospect of getting the best of both worlds. We’re certainly not arguing for abandoning more volatile names: The right picks in the appropriate markets can pay off handsomely. In fact, at times—early in economic recoveries, for example—a well-constructed portfolio should lean toward more volatile securities.

But our research also argues for investors embracing a flexible but all-weather allocation to low-volatility stocks, rather than only buying them opportunistically.

Low-volatility portfolios are not an investment panacea—none exists. But as one component of a well-diversified portfolio, especially in today’s exceptionally skittish market, we find this strategy very appealing.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams.

Andrew Y. Chin is Global Head of Quantitative Research and Investment Risk at AllianceBernstein

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