By – Rahul Shah-Co-Head of Research at Equitymaster
Low volatility has emerged as one of the most significant investment factors in the realm of factor investing. Low volatility investing is essentially investing in the least volatile stocks. But how does it help? Let us look at an analogy from the world of cricket.
It’s no secret that batsmen who have the highest strike rates are the most exciting to watch. But, the harsh reality is that very few of these exciting batsmen are consistent scorers with high career batting averages.
With stocks as well, often the most exciting ones are those that rise, and sometimes fall, very sharply. But very few of these are consistent performers across time and market conditions. This is where the low volatility factor fits in.
For stocks, volatility is measured using well-known statistical measures. Most common among them are
1) Standard Deviation of Returns
2) Variance of Returns
3) Semivariance of Returns
It’s one of the simpler investment factors to adopt since all these can be easily calculated with just stock price and index data. Another significant aspect is the time for which these are calculated. It has been observed that the volatility characteristics of stocks are persistent and don’t change quickly, allowing for a wide range of time periods for analysis.
Low volatility stocks are certainly not the most exciting stocks to invest in. Their secret for generating returns is not how fast and how high they rise, but in how slowly and how little they fall. They may not generate the best returns, but frequently generate the best volatility-adjusted returns. And this can be crucial to investor longevity.
We all know that the longer investors stay invested, the higher their chances of generating inflation beating returns. But this longevity is very heavily influenced by the investment experience, especially in the early stages.
If one were to consider investing as a long road trip, with the destination being the investment goal, then the importance of volatility in investing is the same as that of the quality of the road for the road trip.
If a traveler faces very rough roads early in the journey, it isn’t just uncomfortable but there is a high probability that the trip itself will be abandoned. This probability reduces as the distance traveled increases, but it never really goes away. The investment journey is a very similar one.
If equity investors face extreme volatility in the early stages of their investment, it has the potential of discouraging them from investing in equities completely. Most investors who start investing just before a correction and experience deep losses are irreversibly scarred by their experience.
Consequently, for investors, using the low volatility factor to reduce the volatility of their investment portfolio isn’t just a good idea, it may well be crucial to their future financial wellbeing.