The Low Volatility Anomaly: Why “Boring” Stocks Crush “Exciting” Stocks
The Low Volatility Anomaly: Why “Boring” Stocks Crush “Exciting” Stocks
๐ WHO THIS IS FOR
- Target Profile: Investors nearing retirement or those with low risk tolerance who still need equity-like returns.
- Primary Objective: Capital Preservation & Compound Growth (Minimizing drawdowns to maximize geometric return).
- Not Suitable For: Aggressive traders seeking to outperform during speculative bubbles (e.g., dot-com boom).
EXECUTIVE SUMMARY
- The Theory: The Capital Asset Pricing Model (CAPM) states that risk and return are positively correlated. To get higher returns, you must buy higher Beta (volatile) stocks.
- The Anomaly: Real-world data proves the opposite. Since 1929, the least volatile stocks have outperformed the most volatile stocks on a risk-adjusted basis, and often on an absolute basis. This is the “Low Volatility Anomaly.”
- The Reason: Investors are irrational. They overpay for “Lottery Tickets” (high volatility stocks with a small chance of huge gains) and neglect “Bonds with Dividends” (low volatility stocks like Utilities/Staples).
- Authority Baseline: This analysis is grounded in the seminal work of Haugen & Baker (1991), who first identified that low-risk stocks defy efficient market theory.
Winning in the stock market is not about hitting home runs; it’s about avoiding strikeouts. If you lose 50%, you need a 100% gain just to get back to even. Low Volatility Investing wins by losing less. By falling only 10% when the market falls 20%, you preserve a larger capital base to compound when the market turns. According to Team BMT Analysis, this is the most reliable “defensive” equity strategy for turbulent times. Source: S&P Dow Jones Indices / MSCI Research
Scenario: Two portfolios start with $100.
- Portfolio A (High Volatility): Up 50%, then Down 33%.
Arithmetic Avg: 8.5%.
Final Value: $100 * 1.5 * 0.67 = $100.50. (Basically flat). - Portfolio B (Low Volatility): Up 10%, then Down 5%.
Arithmetic Avg: 2.5%. (Looks lower).
Final Value: $100 * 1.10 * 0.95 = $104.50. - Verdict: Low volatility creates higher wealth even with lower average returns. This is the difference between Arithmetic and Geometric compounding.
BMT Verdict: Volatility drag is the silent killer of portfolios. The Low Volatility anomaly is not a fluke; it is a structural inefficiency caused by institutional mandates (benchmarking) and retail gambling instincts. Betting against volatility is betting on mathematics.
Crisis Performance (2008)
| Asset Class | 2008 Drawdown (%) |
|---|---|
| S&P 500 (Market) | -37.0 |
| S&P 500 Low Volatility (SPLV) | -21.4 |
*Chart Note: In a crash, Low Vol stocks act as a parachute. Falling 21% is painful, but falling 37% is catastrophic. The Low Vol investor recovered their peak wealth years earlier than the market investor.
Historical Context: In 2022, as the S&P 500 entered a bear market (-19%), High Beta Tech stocks crashed -40%. Meanwhile, Low Volatility indices (USMV) fell only -5% to -10% for much of the year. This divergence saved retirees from the “Sequence of Returns” disaster.
โ BOUNDARY CLAUSE: This Structure Breaks Down If:
- Interest Rates Spike Rapidly: Low Vol stocks are often “Bond Proxies” (Utilities, Staples). If rates rise fast (like 2022), they can suffer alongside bonds, though usually less than Growth stocks.
- Raging Bull Market: In a FOMO rally (e.g., 2020), Low Vol will lag the market significantly. You must be willing to underperform when your neighbors are getting rich on meme stocks.
Execution Protocol
SPLV (S&P 500 Low Volatility): Purest approach. Buys the 100 least volatile stocks. Sector concentration can be high (e.g., 40% Utilities). USMV (MSCI USA Min Vol): Optimized approach. Uses an algorithm to minimize portfolio volatility while constraining sector weights. Better diversification.
Don’t think of Low Vol as just “Stocks.” Think of it as a hybrid. If you are 60/40, you might move to 70/30 by adding 10% Low Vol equities. This increases yield and growth potential while keeping overall risk similar.
The hardest part is psychological. When the S&P 500 is up 20% and Low Vol is up 10%, you will want to sell. Don’t. You hold Low Vol for the bad times, not the good times.
This strategy prioritizes “Sleep-Adjusted Returns.” If you check your portfolio daily and crave action, this will frustrate you. If you check it yearly, this will delight you.
WEALTH STRATEGY DIRECTIVE
- Do This: Use USMV or SPLV as a core holding in a retiree portfolio. It provides a smoother ride, reducing the urge to panic sell during crashes.
- Avoid This: Buying High Yield Dividend funds thinking they are Low Vol. High Yield can be a trap (distressed companies). Always check the “Beta” of the fund. It should be < 0.8.
Frequently Asked Questions
Is Low Vol just Value investing?
They overlap, but they are distinct. Value buys cheap stocks (which can be volatile). Low Vol buys stable stocks (which can be expensive). Often, Low Vol trades at a premium P/E because safety is expensive.
Does it work internationally?
Yes. EFAV (EAFE Min Vol) and EEMV (Emerging Min Vol) work even better than in the US because international markets are more volatile. The anomaly is global.
What is the downside?
Interest rate sensitivity. Because these companies pay dividends and are stable, they compete with bonds. If bond yields soar to 6-7%, investors might dump Utilities for Treasuries.