Overview

Behavioral finance theories tell us that investors strongly prefer to avoid losses over acquiring gains of the same magnitude. Essentially, these theories show that the psychological pain we feel from losing outweighs the psychological pleasure we get from winning.

These theories are at odds with the traditional schools of thought that have molded our understanding of how investors behave in financial markets, but they are likely more relatable to the average investor concerned about losing money. Due to these views, many academic papers documenting investor behavior reveal a distinct investor preference for reducing downside risk. Specifically: Outperformance during bear markets is more important to investors psychologically than is outperformance during bull markets.

So, how can investors seek enhanced downside risk protection without the use of cash, bonds or options? Through targeted and concentrated exposure to low volatility stocks.

In our research-based white paper, Low Volatility Investing with Conviction , we demonstrate how targeted exposure to the low volatility factor through concentrated portfolios of low volatility stocks enhances the downside risk reduction benefits of low volatility investing. The analysis reveals the ubiquitous presence of this low volatility anomaly across multiple market capitalizations and during periods of increasing market risk.

We studied portfolios consisting of 200, 100, 50, and 25 stocks sorted by low volatility across the S&P 500 large-cap market, the S&P 400 mid-cap market, and the S&P 600 small-cap market over the 20-year period from August 1, 1996 through August 1, 2016. This evaluation period encompassed multiple market cycles, including the tech bubble of the early 2000s and the mortgage crisis and recovery of 2007-2009. The analysis focused on the portfolio’s downside risk characteristics relative to their respective indices and included measures of relative risk, downside beta, downside capture, and rolling maximum drawdowns.

Key Findings

Based on our analysis, we arrived at the following key conclusions:

1. Low volatility investing substantially reduces downside risk. As low volatility portfolios become more concentrated in less volatile stocks, the portfolios exhibit less relative downside risk and tail risk across multiple statistics and size markets.

2. The benefits of low volatility investing are most pronounced in turbulent market environments. As the market becomes more volatile, concentrated low volatility portfolios reduce relative downside risk even further, suggesting that low volatility investing adds enhanced value during turbulent times.

3. Highly concentrated low volatility portfolios mean greater downside protection. The results suggest that with low volatility investing, smaller portfolios don’t necessarily mean less diversification, but instead provide even more protection to the downside.

Conclusion: Low volatility can protect you on the downside.