Evidence and Explanations for the Low-Volatility Anomaly
Summary
The discussion examines whether low-volatility stocks outperform high-volatility stocks over long periods and whether the result depends on the sample window. It points to research across equities and other asset classes that reports weak or absent positive relationships between conventional risk measures, such as volatility or beta, and average returns. The cited explanations include investor preference for lottery-like payoffs and demand for high-volatility assets from investors who cannot use leverage but seek higher returns; that demand may raise prices and lower expected returns.
The evidence is presented through references to published studies and a cross-asset survey, rather than new calculations in the discussion. It also raises methodological caveats: findings may depend on how risk and return expectations are measured, the chosen period, and the holding horizon. One answer questions a strategy that refreshes its highest-volatility stock group annually and suggests longer holding periods could produce different results. The discussion therefore supports considering the anomaly while treating its size, robustness, and explanation as unsettled.
Key ideas
- Studies cited in the discussion report that volatility and beta often do not predict higher average returns.
- The low-volatility pattern has been examined across equities and other asset classes.
- Investor demand for lottery-like payoffs may help explain why riskier stocks have lower expected returns.
- Investors unable to use leverage may bid up volatile assets while pursuing higher returns.
- Conclusions can vary with the measurement method, sample period, and holding horizon.
Tags
Full text
# Do low volatility stocks outperform high volatility stocks over the long run? # Do low volatility stocks outperform high volatility stocks over the long run? A recent article from Forbes seems to indicate that low volatility stocks outperform high volatility stocks over the long run. Does anyone have any supporting or contradicting evidence to this claim? The study cited studied returns for the entire stock market and the 1,000 largest stocks from 1968 to 2008. Note that the answer to this question is really a simple yes or no, however the larger issue is whether or not the period under study was cherry picked and if different results would have been obtained using different end dates. ## Answer by vonjd (score 5, accepted) https://quant.stackexchange.com/a/713 This current paper is highly relevant to your question: Risk and Return in General: Theory and Evidence (Eric G. Falkenstein) > Empirically, standard, intuitive measures of risk like volatility and beta do not generate a positive correlation with average returns in most asset classes. It is possible that risk, however defined, is not positively related to return as an equilibrium in asset markets. This paper presents a survey of data across 20 different asset classes, and presents a model highlighting the assumptions consistent with no risk premium. The key is that when agents are concerned about relative wealth, risk taking is then deviating from the consensus or market portfolio. In this environment, all risk becomes like idiosyncratic risk in the standard model, avoidable so unpriced. BTW: The original paper Forbes references to can be found here: Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly (Malcolm Baker, Brendan Bradley, and Jeffrey Wurgler) ## Answer by Richard Herron (score 6) https://quant.stackexchange.com/a/721 The theory predicts that expected risk and expected return should be positively related. But no one has convincingly proved this. The results are very sensitive to how you determine the expectations of risk and return and the timeline you use. Many have shown that there isn't a positive trade-off between risk and return in a CAPM-framework (i.e., Fama and French 1992 showed that $\beta$ has no predictive power in the cross section of returns -- although in 1993 they "saved" $\beta$ by adding two more factors). What is odd about this Baker et al research is that they're buying the 20% with the highest vol and holding them for only one year. They're are constantly investing in the most uncertain stocks without ever really allowing the uncertainty to get resolved. I would be interested in how these results change with a two to five year holding period (e.g., I imagine in the mid 90s both amazon.com and pets.com where volatile; if you held both for one year, then you may or may not come out ahead; but if you held both for five years, pets.com delists and amazon.com skyrockets; but this is anecdotal and far from convincing.) ## Answer by Tal Fishman (score 2) https://quant.stackexchange.com/a/1483 Blitz and Van Vliet (2007), published in the Journal of Portfolio Management, has also tested this proposition on a global dataset. Some other important papers on this phenomenon are: - Ang et al. (2006) - Clarke, de Silva, and Thorley (2006) (also see here) - Sullivan and Lee (2010) Currently the literature is moving more towards explaining this phenomenon as a result of idiosyncratic risk rather than overall volatility (see Gao, Yu, and Yuan (2010) and Bali and Cakici (2008)). Possible explanations for this phenomenon are given by Barberis and Huang (2008) and Bali, Cakici, and Whitelaw (2010). They suggest a "preference among investors for assets with lottery-like payoffs." ## Answer by Patrick Burns (score 2) https://quant.stackexchange.com/a/1948 Antti Ilmanen in his book Expected Returns shows this phenomenon in assets in addition to equities. So it seems to be a general phenomenon rather than due to a cherry-picked example. He also discusses (page 393) an explanation in addition to the lottery idea. Investors that can not leverage but who seek higher returns will overweight high volatility assets. This will tend to drive up their prices and hence drive down their expected returns.
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.