Low-volatility investing: a long-term perspective
Over the long-run, risk and return within equity markets are not related. Selecting stocks with a higher risk, does not automatically lead to a higher return. This empirical finding contradicts investment theory, which states that higher risk should give a higher expected return.
The figure below shows the average compounded return of portfolios sorted on historical volatility and beta for the 80-year period from 1931-2009.1 It shows that high-risk stocks are especially unattractive, based both on the return, which is lower, and on risk, which is higher. On the other hand, low-volatility portfolios are especially attractive because they increase the return per unit of risk. The return/risk ratio over the period is 0.68 for the lowest volatility portfolio and steadily decreases to 0.15 for the highest-volatility portfolio.
Based on these empirical results one should avoid the most volatile stocks. For investors with an absolute return focus, for example, investors aiming to maximize the Sharpe ratio, the stocks with the lowest volatility should be selected. Still, it is interesting to investigate how stable these results are over time. Eighty years is a very long time period and much longer than the investment horizon of most investors. If we zoom-in on the eight different decades comprising the period from 1931-2009, has the relation between risk and return always been negative?
