The Low Volatility Factor Effect in Stocks and Its Impact on Investment Strategies cover
Papers With Backtest: An Algorithmic Trading Journey

The Low Volatility Factor Effect in Stocks and Its Impact on Investment Strategies

08min |23/11/2024
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In this episode of "Papers With Backtest: An Algorithmic Trading Journey," we dive deep into the compelling world of the low volatility factor effect in stocks, a topic that challenges the conventional high-risk, high-reward investing narrative. As seasoned traders and investors, we know that the landscape of algorithmic trading is ever-evolving, and understanding nuanced strategies can be the key to outperforming the market. Join us as we dissect a pivotal research paper by Blitz and Van Vliet titled "The Volatility Effect: Lower Risk Without Lower Return," which provides groundbreaking insights into how a portfolio composed of the least volatile global large-cap stocks astonishingly outperformed the market by an average of 12% annually from 1986 to 2006.


Throughout this episode, we emphasize the significance of low volatility investing, a strategy that focuses on stocks exhibiting less dramatic price fluctuations compared to the overall market. This approach not only enhances risk management but also opens up new avenues for potential returns, making it a vital consideration for any serious investor. Our hosts meticulously break down how the researchers implemented this strategy, honing in on the top 10% of the least volatile stocks and exploring the potential benefits of shorting high volatility stocks.


Furthermore, we delve into the intricate dynamics of market behavior and investor psychology, examining how these factors play a crucial role in the effectiveness of the low volatility strategy. While we acknowledge the limitations of this approach during robust bull markets, we argue that the principles of low volatility investing can provide a solid foundation for building a resilient investment portfolio.


As we navigate through the complexities of this strategy, we invite our expert audience to reflect on their own investment philosophies and consider integrating low volatility principles into their trading methodologies. The insights shared in this episode are not just theoretical; they are practical applications that can enhance your algorithmic trading journey and lead to more informed decision-making.


By the end of this episode, you will have a clearer understanding of how to leverage the low volatility factor effect to create a more balanced investment approach. Whether you are a seasoned trader or an aspiring investor, this discussion promises to equip you with valuable knowledge that can elevate your trading strategy. Tune in to "Papers With Backtest" and discover how embracing low volatility can transform your investing journey for the better.


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Transcription

  • Speaker #0

    Hello, welcome back to Papers with Backtest podcast. Today, we dive into another algo trading research paper. We're looking at the low volatility factor effect in stocks. Yeah. The idea that playing it safe might actually be the most profitable move in the market.

  • Speaker #1

    It's a fascinating concept, isn't it? It really challenges that classic high risk, high reward idea that's so ingrained in finance.

  • Speaker #0

    Totally. We're digging into a paper by Blitz and Van Vliet called The Volatility Effect, Lower Risk Without Lower Return. And get this, They found that between 1986 and 2006, a portfolio of the least volatile global large cap stocks actually outperformed the market.

  • Speaker #1

    Outperformed by how much, though? That's the real question.

  • Speaker #0

    OK, get this. By an average of 12 percent per year.

  • Speaker #1

    12 percent.

  • Speaker #0

    12 percent. I mean, can you imagine if we'd all been factoring in volatility like this all along?

  • Speaker #1

    12 percent annually is significant, no doubt. What makes it even more compelling is this wasn't some isolated case. The research shows this low volatility effect has popped up in other markets, too. We're talking the U.S., Europe, Japan. And it's not just a matter of timing the market, either. This holds true even when compared to other popular strategies like value or momentum investing.

  • Speaker #0

    OK, so we're not just talking about a fluke here. This seems like a pretty solid pattern. But before we go any further, I think it's important to clarify what we even mean by low volatility.

  • Speaker #1

    Absolutely. When we talk about low volatility investing, we're essentially looking at stocks that tend to move up and down less dramatically than the overall market. They're the steady eddies, not the wild horses, so to speak.

  • Speaker #0

    I like that analogy. So how did Blitz and VanVleet actually put this low volatility strategy into practice?

  • Speaker #1

    Their approach was surprisingly straightforward. Each month, they'd rank stocks based on their volatility over the previous three years. And here's the kicker. They used weekly volatility, not daily or monthly. Weekly.

  • Speaker #0

    OK. Why is that significant?

  • Speaker #1

    It suggests a focus on the long term. By looking at weekly data, you smooth out the day-to-day noise and get a better sense of a stock's inherent stability over time.

  • Speaker #0

    Gotcha. So it's about seeing the forest for the trees. So they rank these stocks, then what? What do they actually do with that information?

  • Speaker #1

    They kept it simple. By the top 10% of the least volatile stocks, what we call the lowest decile.

  • Speaker #0

    Decile, just for clarity there.

  • Speaker #1

    Right. Decile just means they divided the stocks into 10 groups based on their volatility.

  • Speaker #0

    Makes sense. So they essentially loaded up on those calm, cool and collected stocks, right?

  • Speaker #1

    Exactly. They mainly focused on going long on these low volatility stocks, but they did explore the potential of shorting the highest volatility docile for potentially maximizing returns.

  • Speaker #0

    Interesting. So they were open to playing both sides of the coin. But even with just the buy low volatility approach, they saw impressive results, which begs the question, why does this work? It seems counterintuitive. Why would playing it safe actually lead to bigger games?

  • Speaker #1

    That's the million-dollar question, isn't it? And the answer is multifaceted. It has to do with market dynamics, investor behavior, and maybe even a bit of human psychology.

  • Speaker #0

    Okay, so let's unpack those market dynamics. What's going on behind the scenes that might explain why this strategy works?

  • Speaker #1

    Well, one factor could be leverage, or rather the lack of it. You see, in a perfectly efficient market, investors should... theoretically be using leverage to amplify their returns, even on those low risk assets.

  • Speaker #0

    So if you know something is a good bet, you borrow some money to bet even bigger, win even bigger, right?

  • Speaker #1

    Exactly. But in reality, most investors don't or can't utilize massive leverage. Maybe it's risk aversion, maybe it's institutional constraints, but whatever the reason this limitation creates a kind of inefficiency in the market.

  • Speaker #0

    Interesting. So how does that tie back to the low volatility strategy?

  • Speaker #1

    It's like, Everyone else is playing poker with matchsticks and we're sitting here with a stack of chips. We don't need to make risky bets to come out ahead.

  • Speaker #0

    That's a great analogy. So these low-risk stocks are kind of like those undervalued properties in up-and-coming neighborhoods. They're not flashy, but they offer solid returns if you know where to look.

  • Speaker #1

    Precisely. Now, another piece of the puzzle might be the way the investment industry itself operates. You often have this two-step process. First, money is allocated to different asset classes. And then portfolio managers pick specific stocks within those categories to try and, you know, beat a benchmark.

  • Speaker #0

    So there's pressure to find those star performers, even if it means taking on more risk.

  • Speaker #1

    Exactly. This can create a bit of a self-fulfilling prophecy where managers feel compelled to chase those high volatility, high growth stocks, even if the fundamentals don't necessarily justify the risk.

  • Speaker #0

    So it becomes a feedback loop. Everyone piles into the same risky assets, driving the prices up even higher, while those... less volatile, potentially undervalued stocks get left in the dust.

  • Speaker #1

    It's a plausible explanation. And then, of course, we have to factor in the human element, right? Behavioral biases can play a significant role in all of this.

  • Speaker #0

    Okay, this is where it gets really interesting for me. What are some of the biases that might be leading investors astray here?

  • Speaker #1

    Well, consider this. Do you think some investors, maybe subconsciously, view high volatility stocks as lottery tickets? There's a certain allure to the possibility of striking it rich quickly, even if the odds are slim.

  • Speaker #0

    Yeah, I can see that. It's like the thrill of the gamble.

  • Speaker #1

    Exactly. This lottery ticket bias could lead to certain assets being overpriced simply because they have the potential for a huge payout.

  • Speaker #0

    That makes a lot of sense. It's like choosing to play the slot machine over blackjack. The slots might seem more exciting with the promise of a massive jackpot, but in the long run, a more strategic approach is likely to yield better results.

  • Speaker #1

    Exactly. Now, it's crucial to remember that no investment strategy is foolproof, and low volatility investing is no exception. There are periods when this approach might not be the top performer.

  • Speaker #0

    Right. So what are some of the caveats investors should be aware of? When might this strategy not work as well?

  • Speaker #1

    One thing to keep in mind is that low volatility strategies tend to lag behind in strong bull markets. When the market is surging upwards, those high growth, high volatility stocks everyone's chasing can really take off.

  • Speaker #0

    That makes sense. But isn't everyone making money hand over fist during a bull market anyway? Is it really a big deal to maybe not be at the very top of the pack if your strategy really shines when things take a turn?

  • Speaker #1

    It's a valid point. It ultimately boils down to your personal risk tolerance and investment goals. But here's the key takeaway. The study found that these low volatility portfolios more than made up for their bull market lag when things got rough. They acted as a buffer during downturns.

  • Speaker #0

    So it's like choosing to drive a sturdy, reliable car instead of a flashy sports car. The sports car might be more exciting for a joyride, but in a storm, that reliable car is going to give you peace of mind.

  • Speaker #1

    That's a great analogy, and it highlights that aligning your investment strategy with your risk tolerance and long-term goals is essential. Speaking of which, the study actually found that the biggest drawdown for the lowest volatility portfolio was only about two thirds that of the overall market.

  • Speaker #0

    Meaning you ride out those market dips with less drastic losses. It's about staying in the game, not getting knocked out by volatility.

  • Speaker #1

    Exactly. And remember, you don't have to go all in on a low volatility approach to benefit. Even incorporating some of these principles, allocating a portion of your portfolio to these steadier stocks. can act like a built-in safety net. It's about finding that balance between risk and reward.

  • Speaker #0

    This has been a fascinating deep dive. We've learned that playing it safe might not be so boring after all. The potential for low volatility investing to generate significant returns while mitigating risk really challenges conventional thinking.

  • Speaker #1

    Indeed. We've explored the mechanics of the strategy, the economic and behavioral reasons behind its potential effectiveness, and even touched on some real-world applications and considerations.

  • Speaker #0

    For me, the most compelling takeaway is how this strategy challenges the traditional risk-reward paradigm. It really makes you think differently about how we approach investing.

  • Speaker #1

    Absolutely. It underscores the importance of considering volatility as a factor, regardless of your investment approach.

  • Speaker #0

    As we wrap up, any final thoughts you want to leave our listeners to ponder?

  • Speaker #1

    Here's something to consider. If low-volatility investing continues to demonstrate its potential, could we see a shift in how investors perceive and approach risk? Could this... anomaly become a more mainstream strategy? It's certainly something to keep an eye on.

  • Speaker #0

    It's a fascinating question. And on that note, thank you for tuning in to Papers with Backtest podcast. We hope today's episode gave you useful insights. Join us next time as we break down more research and turn it into practice. And for more papers and backtests, find us at https.paperswithbacktest.com. Happy trading!

Chapters

  • Introduction to Low Volatility Factor Effect

    00:00

  • Understanding the Research and Its Findings

    00:22

  • Defining Low Volatility Investing

    01:15

  • Implementing the Low Volatility Strategy

    02:09

  • Market Dynamics and Behavioral Factors

    02:52

  • Caveats of Low Volatility Investing

    05:41

  • Conclusion and Final Thoughts

    07:28

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