Research Article #43 - The Volatility Effect
A strategy with the aim of achieving lower risk without lower returns
There´s a volatility effect, that has been widely documented, that suggests that lower-risk stocks tend to outperform their higher-risk counterparts on a risk-adjusted basis.
This concept defies the traditional risk-return tradeoff that is often a subject of conversation by financial theory, particularly the Capital Asset Pricing Model (CAPM), which tell us that higher risk should correlate with higher returns.
We talk a lot about that idea in these articles. If we’re taking on higher risk, we should also expect to be compensated for it. Even though it can be argued that volatility alone is not necessarily correlated with higher risk.
There’s companies that experience higher volatility, that are far more robust than lower volatility ones.
In U.S. equities, this anomaly has been documented and studied quite a lot, yet it continues to challenge what’s considered normal. Understanding the existence and persistence of the volatility effect is important for investors and traders, as it has significant implications for portfolio management, asset pricing, and market efficiency.
Several factors can contribute to the existence of the volatility effect in U.S. equities.
Behavioral biases among investors, such as overconfidence and the preference for lottery-like payoffs, lead to the overvaluation of high-volatility stocks and the undervaluation of low-volatility ones.
Institutional constraints, including leverage limits and benchmarking against market indices, can also drive demand for high-volatility stocks, further distorting their prices.
Market frictions such as transaction costs, short-selling constraints, and liquidity issues can exacerbate these biases, allowing the volatility effect to persist over time.
Also other studies shows that low-volatility stocks tend to exhibit more stable cash flows, lower financial leverage, and less exposure to macroeconomic shocks, contributing to their superior risk-adjusted performance.
The existence of the volatility effect challenges the assumption of efficient markets and suggests that volatility and return are not always directly correlated.
Let’s find out more!
Index
Introduction
Index
Strategy’s Thesis
Multi Asset Long-Only Model Performance Analysis
Edge Effect in U.S. Equities
Parameter Settings Overview
Conclusion
Python Code Section
Strategy’s Thesis
Clarke, de Silva, and Thorley (2006) provided really interesting conclusions into the volatility effect by analyzing the performance of minimum-variance portfolios constructed from the 1,000 largest U.S. stocks from 1968 to 2005.