Slow and steady wins the race, even when it comes to stocks. Given enough time, boring stocks with low volatility outperform their more volatile and exciting cousins, suggests new research by Paris-based BNP Paribas Investment Partners.
“Investors go to the market in search of high returns, and they think they need to take greater risks to get the higher returns,” says Raul Leote de Carvalho, head of quantitative strategies and research with BNP IP. “It is actually the stocks with the least risk, as measured by volatility, that provide the highest returns over time.”
At a recent seminar in Toronto, de Carvalho cited statistics illustrating that between 1995 and 2011, the MSCI world index had an average annual return of 5.6%, while BNP IP’s proprietary low-volatility strategy had obtained a return of 9.6% – for an average annual outperformance of four percentage points for the low-volatility stocks. Research shows the theory works at least as far back as 1926, de Carvalho says.
This strategy applies across all geographical areas, including Asia, North America, Europe and Japan, de Carvalho says, as well as to almost all market sectors. In North America, for instance, the strategy would steer investors away from Apple Inc. and toward more sedate companies, such as TransCanada PipeLines Ltd., Enbridge Inc. and Tim Hortons Inc.
“It boils down to investor behaviour,” de Carvalho says. “There is higher demand for the more volatile stocks. Those are the ones that tend to make the headlines and give people something to talk about. The large price movements up or down [have] kept them in the news and make the stocks an easier sell. People tend to invest in what they know.”
The pressure to achieve juicy returns also drives people to highly volatile stocks in search of the big gains. In addition, there is also peer pressure, even among professional portfolio managers, to include stocks that have done well lately. The problem is that many people will buy these stocks after they have had a good run, and will then suffer the losses when these stocks inevitably correct.
The steadier stocks may not get the giant gains, but they also don’t get the huge losses; furthermore, they are more resilient in difficult times.
“Investors believe they are prepared to [assume] risk to get returns, and overemphasize their capability for stock-picking,” de Carvalho says. “And a fund manager under pressure to outperform competitors will often go for high-volatility stocks.”
There are always exceptions, of course. One sector in which this strategy has not been working lately is materials, de Carvalho says. But even within volatile sectors, such as energy or small-cap stocks, low-volatility stocks outperform the less stable companies.
“You don’t find the low-volatility stocks only in defensive sectors,” de Carvalho says. “In each sector, you can screen for low-volatility stocks and run the portfolio in a clever way.”
The low-volatility strategy usually lags the indices in fast-moving bull markets, he says. For example, in 2009, the MSCI world index staged a strong recovery of 30%, while BNP IP’s low-volatility strategy gained only 19.1% – a lag of 10.9 percentage points.
There is a preponderance of high dividends among stocks in low-volatility portfolios, de Carvalho adds. These companies also tend to have low levels of debt and healthy returns on both equity and assets, all of which makes them good long-term investments.
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