- Speaker #0
Hello, welcome back to Papers with Backtest podcast. Today we dive into another algo trading research paper.
- Speaker #1
Right.
- Speaker #0
We're looking at the low volatility anomaly in equity sectors 10 years later. It's all about whether this well-known market phenomenon that stocks with lower volatility can sometimes outperform the high flyers still holds true.
- Speaker #1
Yeah.
- Speaker #0
You know, I've always been fascinated by this idea because it seems so counterintuitive.
- Speaker #1
Right.
- Speaker #0
Doesn't more risk? usually mean more reward.
- Speaker #1
That's the classic thinking, isn't it? Yeah. But the low volatility anomaly challenges that very notion. Yeah. This paper takes a deep dive into whether this anomaly is still relevant today, 10 years after the original research. It's like putting a time tested strategy back on trial.
- Speaker #0
I love that analogy. OK, so for our listeners who might be hearing about this for the first time. Yeah. Can we break down what the low volatility anomaly actually is? Sure. What's the history here?
- Speaker #1
Well, the story begins. back in the early 1970s. Researchers started noticing that sometimes the stocks with the lowest volatility, meaning their prices didn't jump around as much, actually delivered better returns than their more volatile counterparts.
- Speaker #0
Interesting.
- Speaker #1
It was a bit of a head scratcher because it flew in the face of traditional finance theory.
- Speaker #0
Okay, so the what is clear. Right. Sometimes less volatile stocks outperform.
- Speaker #1
Exactly.
- Speaker #0
But what about the why? Why does this anomaly
- Speaker #1
Seem to defy the whole risk-return relationship we've all been taught That's the million-dollar question and this paper explores a bunch of possible explanations Okay, one idea is that traditional finance models are often too simplistic Okay, they don't always account for real-world constraints like leverage limits Right meaning how much investors can borrow to amplify their bets got it. These limits can actually prevent anomalies from being fully arbitrage away
- Speaker #0
That's interesting. So it's not just about risk and return in a vacuum. Yeah. It's about how the mechanics of the market itself can impact these anomalies. Right. What other explanations does the paper offer?
- Speaker #1
Well, they also point out that not all investors are purely motivated by maximizing returns. Some prioritize stability and consistent growth, even if it means slightly lower returns on paper. Sure. This preference for stability can, in turn, drive up the prices of low volatility stocks. Right. making them outperform in the long run.
- Speaker #0
Okay. So investor psychology and preferences come into play. Yeah. It's not just about cold, hard numbers. Right. It's about human behavior impacting market dynamics. Exactly. Any other surprises lurking in this paper?
- Speaker #1
One of the things that makes this paper particularly interesting is that it doesn't just look at low volatility stocks in general. Okay. It breaks down the anomaly by sector.
- Speaker #0
Ah, that's where the real meat is. So we're not just talking about traditionally safe sector. sectors like utilities or consumer staples.
- Speaker #1
You got it. OK.
- Speaker #0
The research shows that this low volatility effect can show up across all sectors from tech to energy to financials.
- Speaker #1
They tested this using the MSCI World Index, which covers a wide range of global stocks. They sorted stocks into 10 groups called deciles based on their volatility and then compared the performance of those groups within each sector.
- Speaker #0
OK. Imagine we line up all the stocks in a sector from the wildest roller coaster to the smoothest ride. We then divide that line into 10 equal groups. Yep. This paper is focused on the group with the calmest, most stable stocks.
- Speaker #1
Exactly. And what's fascinating is that even within those high growth, supposedly volatile sectors, the least volatile stocks often held their own, sometimes even outperforming their riskier counterparts.
- Speaker #0
Okay, I'm hooked. Let's talk backtest results.
- Speaker #1
All right.
- Speaker #0
Did this low volatility magic actually work over the past decade? Yeah. What did they find?
- Speaker #1
They looked at data from 2011 to 2020, a full decade that included both bull and bear markets. And the results are pretty compelling. A portfolio made up of the least volatile stocks from each sector consistently outperformed the benchmark.
- Speaker #0
Okay, that piques my interest. But I'm also wary of backtest results. Sometimes they look great on paper, but fall apart in the real world.
- Speaker #1
Of course.
- Speaker #0
What makes these results particularly convincing?
- Speaker #1
What's remarkable is that... The low volatility portfolio not only outperformed, but it did so with less volatility overall. Okay. So not only are you potentially getting higher returns, but you're also getting a smoother ride. Sure. Who wouldn't want that?
- Speaker #0
That's a pretty strong argument in favor of this approach. Yeah. Does the paper dig into why this anomaly seems to hold true across different sectors?
- Speaker #1
They do. And it makes a lot of sense when you think about how different sectors go through their own unique cycles. Sometimes tech is hot. Other times energy is booming by diversifying across all sectors and picking the least volatile stocks within each. Right. You're essentially smoothing out the bumps as those sector cycles play out.
- Speaker #0
So it's like building a portfolio with shock absorbers. Right. Instead of getting whipped around by the ups and downs of individual sectors, you're creating a more stable base. Yeah. That can potentially weather any market storm.
- Speaker #1
Exactly. Now, it's important to note that this doesn't mean you can completely ignore sector dynamics. There will be periods where certain sectors outperform others and that can impact your overall performance. Yeah. But the low volatility approach offers a way to potentially mitigate those sector specific risks.
- Speaker #0
So it's about finding that sweet spot between diversification and taking advantage of sector trends. Right. You're not trying to time the market perfectly. Yeah. But you're also not completely ignoring what's happening in each sector.
- Speaker #1
Right. And that's where the concept of rebalancing comes in. Okay. As sectors ebb and flow. Right. You might need to adjust your holdings to maintain that desired balance. And keep the low volatility advantage working in your favor.
- Speaker #0
Okay. So it's not a set it and forget it type of strategy. Right. There's an element of active management involved. Yeah. But before we dive into the nitty gritty of how to actually trade this. Sure. I'm curious about one thing. Okay. The paper covers a decade of data. Right. How did the low volatility approach perform during specific market events like the COVID crash or the recent tech boom?
- Speaker #1
That's a great question. And it's one we'll explore in detail in the next part of our deep dive. Okay. We'll unpack the paper's backtest results further. Focusing on how the low volatility portfolio performed during those pivotal market moments. We'll also discuss specific trading rules and how you can adapt the strategy to your own risk tolerance and investment goals.
- Speaker #0
Perfect. I can't wait to dig into those details. Stay tuned, folks. We'll be back after a quick break to uncover the real world application of the low volatility anomaly.
- Speaker #1
All right. Let's dive into the heart of the matter. We've established that the low volatility anomaly appears to hold true across various sectors. even during turbulent market periods. Yeah. Now let's examine the specific trading rules outlined in this paper and see how they translate into actionable steps you can take.
- Speaker #0
That's what our listeners are eager to hear. They've got the concept, now they want the blueprint. Right. Give us the nuts and bolts of building a low volatility portfolio.
- Speaker #1
Of course. The paper uses a systematic approach to identify low volatility stocks. Okay. It calculates the volatility of each stock over a specific look back. period. OK. In this case, the three years leading up to the portfolio formation date.
- Speaker #0
OK. So we're peering back in time to assess how wildly a stock's price has swung. Right. Using that as a gauge for its volatility. Exactly. Did they use a particular formula or metric for this calculation?
- Speaker #1
They employed a standard deviation calculation. OK. Which essentially measures the average deviation of a stock's price from its average price over that three year period. OK. They then ranked the stocks within each sec- based on their volatility. Got it. And divided them into 10 groups, those deciles we talked about earlier.
- Speaker #0
So picture like a volatility ranking system. The calmest, most stable stocks within each sector get drafted into our low volatility portfolio.
- Speaker #1
Yeah.
- Speaker #0
But how many stocks from each sector make the cut?
- Speaker #1
The paper strategy selects the 10% of stocks with the lowest volatility from each sector, forming the low volatility portfolio. Okay. This portfolio is then rebalanced monthly.
- Speaker #0
Monthly rebalancing. Yes. That's quite frequent. Why did they choose this specific time frame?
- Speaker #1
Think of it like tending a garden. You couldn't just plant the seeds and walk away, right? Markets are dynamic and volatility can shift over time. Right. Monthly rebalancing allows you to prune out stocks that have become too volatile. Okay. And replace them with fresh, low volatility picks.
- Speaker #0
I like that analogy. Yeah. So we're consistently adjusting our portfolio, ensuring we're maintaining that low volatility edge. Right. But let's talk about the specific market events you mentioned earlier. Okay. How did the low volatility portfolio weather the storms? Yeah. Like the COVID crash or the recent tech boom?
- Speaker #1
That's where the paper's backtest results get really interesting. Yeah. During the COVID crash in early 2020. Right. When markets plunged dramatically. Yeah. The low volatility portfolio experienced a significantly smaller drawdown compared to the benchmark.
- Speaker #0
Smaller drawdown. Yeah. That means it lost less value during that chaotic period.
- Speaker #1
Exactly. And that's precisely what you want from a low volatility strategy. Okay. Especially during times of extreme market stress. Right. It's about capital preservation and minimizing losses when things get rough.
- Speaker #0
Okay. So it passed the stress test during a major market crash. Right. But what about during bull markets? Yeah. Like the recent tech boom. Yeah. Did it keep up with those high-flying growth stocks?
- Speaker #1
That's a great question. And it highlights a crucial point about any investment strategy. Okay. There will always be periods of underperformance during the tech boom when growth stocks were soaring. Yeah. The low volatility portfolio did lag behind. Yeah. But remember, it still generated positive returns. Just not at the breakneck pace of some of those high-risk tech darlings.
- Speaker #0
So it's about understanding that no strategy works perfectly all the time. Exactly. It's about managing expectations and knowing that there will be times when your chosen approach might not be the top performer.
- Speaker #1
Precisely. And that's where discipline and patience come in. Right. Sticking with a proven strategy. OK. Even when it's not the hottest thing on the block. Yeah. Can be challenging psychologically. Of course. But as the paper demonstrates, the long term benefits of the low volatility approach can be substantial.
- Speaker #0
So for our listeners who are thinking, OK, this sounds promising, but. how do I know it will work for me? What advice would you give them? How can they put these insights into action?
- Speaker #1
First and foremost, they need to backtest these concepts themselves. The paper's findings provide a solid foundation, but markets are dynamic. What worked in the past might need adjustments for current market conditions.
- Speaker #0
Backtesting is crucial. It's about taking those academic insights and putting them to the test in the real world, right?
- Speaker #1
Exactly.
- Speaker #0
And that's where Papers with Backtest comes in. We provide the tools and resources you need to backtest these strategies, explore different parameters and adapt them to your own unique trading style and risk tolerance.
- Speaker #1
Exactly.
- Speaker #0
I love that. So listeners, you don't have to take our word for it. Right. Go to Papers with Backtest dot com and experiment with these concepts yourself. Yeah. But before you do, let's talk about risk management. Even though we're dealing with low volatility stocks. We can't forget about risk entirely, can we?
- Speaker #1
Absolutely not. Risk management is paramount in any trading strategy. Right. In the context of a low volatility portfolio. Okay. Diversification plays a critical role.
- Speaker #0
We've all heard the saying, don't put all your eggs in one basket. Oh. But how does diversification specifically apply to a low volatility portfolio?
- Speaker #1
Remember, we're selecting the least volatile stocks across all sectors. Yeah. This inherent diversification helps mitigate sector... specific risks. If one sector experiences a downturn, the impact on your overall portfolio is cushioned by the performance of other sectors.
- Speaker #0
So we're spreading our bets, reducing the risk that any single event could derail our entire portfolio. What other risk management techniques are essential for this approach?
- Speaker #1
Position sizing is crucial. It's not just about what you buy, but how much you buy of each stock. Determining the appropriate position size for each holding in your portfolio based on your risk tolerance and overall portfolio strategy is a vital step in managing risk.
- Speaker #0
So even though we're focusing on low volatility stocks, we still need to be mindful of how much we allocate to each one. Right. We don't want any single position to become so large that it could disproportionately impact our portfolio.
- Speaker #1
Precisely. And then there's the psychological aspect of risk management, which often gets overlooked. Low volatility investing. Right. With its focus on steady, consistent gains rather than those explosive overnight wins. Yeah. It can be challenging psychologically.
- Speaker #0
Because it's not as glamorous as chasing those high-flying momentum stocks.
- Speaker #1
Exactly. When the market is going crazy and everyone seems to be making a fortune on risky bets. Right. It can be tempting to abandon the low volatility ship, even if it's been serving you well.
- Speaker #0
It's like that classic story of the tortoise and the hare. Right. Slow and steady wins the race. Yeah. But it takes discipline. to stick with that approach when you see others speeding ahead. Exactly. Any tips for staying the course when the FOMO, fear of missing out, kicks in?
- Speaker #1
Having a well-defined trading plan is crucial. Okay. Knowing your entry and exit points, your risk tolerance, and your overall investment goals can help you stay focused when emotions run high.
- Speaker #0
So it's about having that mental fortitude. Yes. That pre-commitment to a strategy.
- Speaker #1
Exactly.
- Speaker #0
To prevent those emotional decisions that can often lead to costly mistakes.
- Speaker #1
Absolutely. And remember, the paper's backtest results demonstrate that. On average, the low volatility approach delivers. But those are averages calculated over a long period. Your personal experience might be different.
- Speaker #0
So it's not a guaranteed path to riches. Right. But rather a solid framework that, when executed with discipline and careful risk management, can potentially lead to consistent long-term returns.
- Speaker #1
Precisely. The research provides valuable insights. Yeah. But it's up to each individual trader to take those insights, adapt them to their own circumstances, and implement them with a focus on risk management.
- Speaker #0
Okay. So we've covered the trading rules. Right. The BACTIS results. Yeah. And the importance of risk management. Exactly. What other key takeaways should our listeners remember as they embark on their low volatility journey?
- Speaker #1
One of the most important things to remember is that the low volatility anomaly isn't a standalone strategy. It's a building block. Yeah. Yeah. a piece of the puzzle that fits into a larger trading or investment approach.
- Speaker #0
So we shouldn't think of it as an all or nothing proposition. Yeah. We can integrate this knowledge about low volatility stocks into our existing strategies.
- Speaker #1
Absolutely. Think about it like constructing a house. You have the foundation, the walls, the roof. They all work together to create a complete structure. Right. Similarly, you can combine the low volatility approach with other strategies. To create a robust and well-diversified portfolio.
- Speaker #0
I like that analogy. It makes this concept feel more accessible. Right. And less like this isolated, esoteric thing.
- Speaker #1
Exactly.
- Speaker #0
How would you suggest incorporating low volatility into a broader portfolio strategy?
- Speaker #1
One popular approach is the core satellite portfolio construction. Okay. You might have a core allocation. Let's say 60, 70% of your portfolio. Okay. That's focused on low volatility stocks. Right. This provides a stable base, a sort of anchor. Yeah. That can help smooth out the ride during market turbulence.
- Speaker #0
Okay. So that's our foundation, our bedrock of stability.
- Speaker #1
Exactly.
- Speaker #0
But portfolios need more than just stability, right? Right. They need growth potential, that extra oomph, to really drive returns.
- Speaker #1
Precisely. That's where the satellite portion comes in. Okay. This is where you can allocate to more tactical, higher risk strategies. perhaps even incorporating some of those high flying momentum stocks we discussed earlier.
- Speaker #0
So it's about finding that balance between stability and growth potential. Right. Between playing it safe and taking calculated risks. Exactly. How do we determine that allocation? Yeah. That split between the core and the satellite.
- Speaker #1
That's where it gets personal. Okay. The allocation depends on your individual risk tolerance market outlook. Right. And investment goals. Got it. If you're feeling bullish and want to chase higher returns, you might tilt more towards the satellite allocations. But if you're more risk-averse or concerned about a market downturn, you can always beef up that low volatility core.
- Speaker #0
So it's about having that flexibility to adjust your portfolio based on your own circumstances and your assessment of the market environment.
- Speaker #1
It's not a one-size-fits-all approach.
- Speaker #0
Exactly. And that's what makes this concept so powerful. Right. It's adaptable. It's customizable and it can be tailored to fit a wide range of investment styles. Right. Yeah. Now, we've talked about blending low volatility with other strategies at the portfolio level. OK. But can we also use this insight during our individual stock selection process?
- Speaker #1
You're reading my mind. It seems like this could be a valuable filter. Right. An additional layer of analysis when deciding whether to buy or sell a stock.
- Speaker #0
Absolutely. Let's say you're using fundamental analysis. to evaluate potential investments. Okay. If you're looking at a company's earnings, its debt levels, its management team, you can layer on top of that a low volatility filter. Okay. Look for companies that meet your fundamental criteria. Right. And also exhibit relatively low stock price volatility.
- Speaker #1
So it's like adding another tool to our toolbox. Exactly. Another lens through which to view the market. Right. We're not just saying, I only buy low volatility stocks. Right.
- Speaker #0
But rather... I look for stocks that meet my criteria. A&D happened to exhibit lower volatility.
- Speaker #1
Precisely. And by incorporating this low volatility factor, you're potentially reducing your risk without necessarily sacrificing returns. It's about finding those stocks that offer the best combination of stability and growth potential.
- Speaker #0
It's like having your cake and eating it too. Now, throughout this deep dive, Focus primarily on the stock market. Yeah. But you hinted earlier that this concept of low volatility could potentially apply to other asset classes as well.
- Speaker #1
That's right. Okay. Volatility isn't unique to stocks, bonds, commodities, even cryptocurrencies. Right. They all experience price fluctuations. So the question becomes, does the low volatility anomaly or something similar exist in those markets as well?
- Speaker #0
Now, that's a fascinating question. If so, how could we identify and capitalize on it? Right. What would a low volatility bond strategy look like or a low volatility approach to crypto?
- Speaker #1
That's an area ripe for exploration. Imagine finding low volatility strategies for bonds. Right. That provide a steady income stream while still offering some potential for price appreciation. Okay. Or uncovering hidden gems in the commodity markets. Yeah. That are less prone to wild price swings.
- Speaker #0
It's a whole new frontier. Yeah. It makes you wonder what other market inefficiencies or anomalies are out there just waiting to be discovered.
- Speaker #1
Exactly. And that's what keeps the world of trading and investing so exciting. There's always something new to learn. Yeah. New strategies to explore. Right. And new opportunities to uncover.
- Speaker #0
I love that sense of endless discovery. Right. So for our listeners who are feeling inspired to delve deeper into the world of low volatility, what final words of wisdom would you offer? Sure. What's the most important takeaway from all of this?
- Speaker #1
It all comes down to execution. Okay. You can have the most brilliant trading strategy in the world. Right. But if you don't execute it with discipline, consistency, and careful risk management, it's all for nothing.
- Speaker #0
Execution. It's the bridge between theory and reality, between having a great idea and actually making it work in the markets. Yeah. It's easy to get caught up in the excitement of a new strategy. Right. But without proper execution, it's just a fantasy.
- Speaker #1
Precisely. So for all our listeners out there who are eager to put these low volatility concepts to work, remember, knowledge is power, but execution is king.
- Speaker #0
Well said. Right. Having a solid trading plan, sticking to your rules, and managing risk every step of the way, that's what separates successful traders from those who just dabble.
- Speaker #1
And on that note, I think it's time to wrap up this deep dive. Okay. We've covered a lot of ground today. Yeah. From the theoretical foundations of the low volatility anomaly. Right. To practical trading strategies and the psychological aspects of this fascinating approach.
- Speaker #0
It's been a fantastic journey. We've explored, we've analyzed. And hopefully we've inspired our listeners to take these ideas and make them their own.
- Speaker #1
Exactly.
- Speaker #0
Remember, the world of trading is constantly evolving. So stay curious. Keep learning. Right. And never stop exploring new possibilities.
- Speaker #1
Thank you for tuning in to Papers with Backtest podcast. Yes. We hope today's episode gave you useful insights. Absolutely. Join us next time as we break down more research. Yes. And for more papers and backtests, find us at https.paperswithbacktest.com.
- Speaker #0
Right.
- Speaker #1
Happy trading.
