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  1. Stock Markets: Benefits of low volatility investing

Stock Markets: Benefits of low volatility investing

As one should invest in stock markets to create long-term wealth, low volatility investing process has the potential to deliver great returns

New Delhi | Published: March 7, 2018 2:06 AM
stock market, investment Comparing results with the Nifty50 index, which is often used a proxy for the market, throws interesting insights.

As they say, there is no free lunch in Finance and Economics. If you want to earn higher returns, you have to take higher risk. That’s what they teach in B-schools to the future fund managers. But, when it comes to investing, they have made a small exception to it. A portfolio, usually defined as a combination of assets or securities, can reduce your risk and improves the risk-return trade-off. So the diversification is a free starter in an otherwise no-free-lunch framework. But that’s it. Don’t expect anything freebies beyond this.

While this high-risk, high-return bonhomie works well across asset classes, it has turned on its head within the asset class. Let me explain. Equity has outperformed the bonds across the globe over a long period of time. A reward for opting for a bumpy, volatile and riskier ride than bond investing. And that’s the way it should be, in the high-risk, high-return world.

Low-risk, high-return!

But the same is not the case within the asset class such as equity. There are two popular measures for the risk: Standard deviation and beta. Standard deviation measures the total risk of a stock whereas beta measures the systematic, the risk linked to the market, which you cannot diversify away.

The low-risk stocks have outperformed high-risk stocks across the globe, both in absolute as well as risk-adjusted terms. I know you won’t believe it without evidence as this is akin to free-lunch. So let us look at some evidence from Indian markets.

Indian evidence

NSE has launched two strategic indices with base data of December 31, 2003. Nifty-low-volatility and Nifty-high-beta-50. A low-volatility index is a proxy for low-risk investment strategy and the high-beta index is a proxy for high-risk investment strategy. If the traditional positive risk-return were to hold, the high-beta index would deliver higher returns than the low-volatility index. Of course with higher standard deviation and beta. But, that is not the case. (See graphics for the evidence).

As you can see, the positive risk-return relationship goes for a toss. Since inception, the low-volatility index has delivered more than three times annualized return than high-beta index at half the risk. You can use the measure of your choice-standard deviation or beta. Besides, the dividend yield for the low-volatility index is superior to high-beta index. The same is true for 5-year performance.

Comparing results with the Nifty50 index, which is often used a proxy for the market, throws interesting insights. Low-volatility index has delivered superior returns than the market at less than much lower risk. Low volatility stocks outperforming the market and high-volatility stocks is a global phenomenon. But the question then is who doesn’t want to earn the higher return at lower risk? And if that is so, how such relationship can persist. Well, the answer lies in the fact that we all are human being and biases and preferences like overconfidence drive investors’ preference for high-risk stocks and ignore low-risk stocks.
Low volatility investing works on the principle of winning by losing less. While markets are not predictable, low volatility investing is boring and predictable. Low-risk stocks outperform in falling and range bound markets and underperform in rapidly rising markets. The case in point is last one year return. The Nifty delivered 18.17% return, whereas high-beta index delivered 22.53% return and low-volatility index delivered 16.05% return.

Investors with the myopic view towards investments always want to make quick money in the short period of time and high-risk stocks offer them the illusion of such possibility in fast-rising markets. Punjab National Bank stock being the part of the high-beta index may be a coincidence. But it says a lot about the long-term inferior performance of high-volatility stocks. Low volatility investing is a slow-burn with the potential to deliver great returns at much lower volatility. We should invest to create wealth and not for excitement or prove intelligence.

Mayank Joshipura is professor & chairperson (Finance), School of Business Management, NMIMS, Mumbai

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