Stock Volatility: Not What You Might Think

One criticized theory in portfolio management is the presumption that in order to obtain higher returns you have to assume greater risk.  The concept that higher risk equate to higher returns is the premise behind the Capital Asset Pricing Model (CAPM) and the Efferent Market Hypothesis (EMH).


This is a very good piece by Charles Lahr at PIMCO the largest bond management firms in the world.  The point of the article (which is told through many data points and charts which I always find helpful) is to show how you can increase your return by taking on less risk.


Here are a few points from Stock Volatility: Not What You Might Think

• For equity investors, the clearest takeaway is that for the long-term investor, higher risk doesn’t necessarily equate with higher returns. In fact, our data suggest that lower risk can lead to higher returns over the long term. As a result, passive investors should be rigorously examining their volatility exposures and return expectations. Correspondingly, we believe active investors should be cognizant of this relationship and consider low volatility stocks as an area to mine for long-term ideas.
• To be sure, it can still be possible for higher volatility investing to create attractive returns. But we believe it’s likely to be obtained only with a very adept manager as it typically takes much more skill, analysis and effort to effectively manage a portfolio of high volatility stocks. A potentially less risky way to obtain attractive long-term equity returns is with lower volatility stocks, and we believe skilled active management can add to that proposition. 
• On the topic of low volatility stocks being consistent with value investing, recall that according to Ben Graham, a legitimate investment operation with a value philosophy should produce long-term returns as well as the return of principal. Since some low volatility equities may be priced richly, an active value philosophy can help discover undervalued investment opportunities within the low volatility universe and exclude stocks that aren’t – a powerful combination. Ultimately, we believe an intelligent approach to both investing and understanding risk is most likely to produce the “holy grail” of equity investing – the potential for lower risk and higher returns.