The sanity in low volatility for consistent returns

Imagine you’re planning a trek up a mountain. Would you choose a steep, uncharted path for the thrill, knowing it’s filled with risks or a steady, well-marked trail that gets you to the top safely? Investing works in the same way. The allure of high returns often tempts us to take higher risks, but the journey doesn’t always guarantee success. Sometimes, the path of lower risk leads not only to safer outcomes but also to surprisingly rewarding heights. So, how do you navigate this climb? Let’s explore the power of the low-volatility strategy.

Understanding risk in investing

Investment management is fundamentally about balancing risk and reward. Risk is not inherently bad; it’s a necessary component of earning returns. However, effective risk management begins with understanding and quantifying risk, a process that employs various statistical and financial measures. One key metric, standard deviation, quantifies the variability of returns. A lower standard deviation indicates more stable returns.

Rethinking the “high risk, high return” paradigm

The traditional risk-reward trade-off suggests that higher returns require taking higher risks. Yet, the low-volatility anomaly challenges this notion, highlighting a paradox where securities with lower volatility or beta often outperform their higher-risk counterparts. This defies conventional expectations and reshapes our understanding of the risk-return relationship.

Historical performance

An analysis of the historical relationship between risk and return reveals the effectiveness of the low-volatility strategy. Using the BSE Low Volatility TRI as a proxy for the “Low-Risk Index,” the strategy has consistently outperformed its high-risk counterparts from 2005 to 2024. Specifically, the Low-Risk Index delivered an impressive 24x growth compared to the High-Risk Index’s modest 3x growth.

This consistent performance challenges the traditional “high risk, high return” paradigm and demonstrates that substantial returns can be achieved with lower levels of risk.

Behavioral biases and the Low Volatility Anomaly

The Low Volatility Anomaly can be partially explained by behavioural biases that influence investor decision-making. A key factor is the preference for lottery-like returns. High-risk stocks promise huge rewards but often underdeliver. Conversely, low-volatility stocks, often perceived as “boring,” are neglected despite their strong fundamentals and consistent performance. This undervaluation creates opportunities for superior long-term returns.

Another contributing bias is overconfidence. Many investors chase high-risk stocks, believing they can identify future winners, which inflates the prices of such stocks and leads to underperformance. By focusing on low-volatility stocks, investors can avoid the pitfalls of speculative demand.

The drawdown advantage

Low-volatility stocks tend to experience smaller drawdowns during market downturns, allowing for quicker recovery and more consistent long-term growth. In contrast, high-volatility stocks face deeper declines, making it harder for them to regain losses. This characteristic enhances the ability of low-risk strategies to deliver steadier returns, particularly in volatile market conditions.

Conclusion

Investing isn’t about chasing high-risk paths for the thrill of high returns; it’s about balancing risk and reward for sustainable growth. Historical data shows low-risk investments offer better risk-adjusted returns with fewer drawdowns. They demonstrate resilience during market downturns with smaller declines and quicker recoveries. By focusing on low-risk strategies, investors can achieve consistent long-term growth, avoid unnecessary volatility, and recover swiftly during downturns. Rethinking the traditional “high risk, high return” model can help investors navigate their financial journey more effectively.