A Simple Tip To Potentially Lower Downside Risk And Improve Returns

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Includes: AAPL, DRII, FB, JPM, PSX, T, USB, VZ
by: Kurtis Hemmerling

Summary

An increase in volatility does not necessarily translate into higher returns as CAPM forecasts.

Two volatility measures are used: Beta and Average True Range.

Strategy simulations see a marked improvement when showing a preference for stocks of lower volatility.

I can easily recall the initial euphoria I felt after reading the book, How To Make Money In Stocks, by William J. O'Neil. I was convinced that this was the 'secret sauce' to finding the next big stock. What I found in practice was that this high momentum system carried a lot of down-side risk...and I mean a lot! The system focuses on small high-growth companies making breakouts but where valuation is generally ignored. To be fair, many people use this system and claim to do well by it - I wasn't one of those people.

After my disappointment I read through dozens of investment books, each one with its tale of endless riches using some magic formula. What these books often fail to show you is how bad things can turn when the system fails. This can especially be true of value strategies in bear markets because you often fall into value traps of high risk. The American Association of Individual Investors (AAII) tracks over 60 unique investment strategies and some have lost over 80% of their worth in bear markets - and that is before taking into account trading costs such as the bid/ask spread, price slippage and any brokerage fees!

If you are going to dabble in various stock-picking strategies, one way to potentially limit your downside loss is to select highly ranked stocks with relatively low volatility. Let's have a look at what I mean.

The first step is to have a method to sort through stocks based on volatility.

Low Volatility Ranking System

Using the tools at Portfolio123 I have built a simple volatility ranking system with 2 components:

  • Monthly Beta averaged over 5 years
  • Average True Range Normalized over past 100 trading days

Beta compares market to stock movements. If the stock moves up and down to the same degree as the market, it is said to have a Beta of 1. If the stock moves perfectly inverse to the market, it would have a Beta of -1. If the stock moves parallel to the market but twice as much, the Beta would be 2. Think of Beta as being like leverage. I prefer stocks with lower Beta.

Average True Range Normalized (OTCPK:ATRN) looks at the daily range of prices but also includes any over-night price gaps from the previous close. This factor will help us pick stocks with lower daily price volatility.

If you don't have access to a platform to screen for these two factors, just use Beta. It will get you most of the way there and is commonly reported on.

Testing Volatility and Performance in the Russell 3000 Index

This next chart tests the 'low volatility' ranking system in the Russell 3000 index over the past 14 years. Stocks are sorted into 20 groups (150 stocks per portfolio) based on the average volatility ranking as per the two factors mentioned above. Every 4 weeks the stocks are re-sorted and placed in the appropriate volatility group. The bar on the far left is the annual performance of the Russell 3000 index plus dividends. The next bar represents the average annual return of the portfolio with the highest volatility. The farther right you go, the less volatile the stocks are in that portfolio.

Russell 3000 Volatility and Performance Backtest

You can see a direct inverse relationship between volatility and price performance. This simulation doesn't support the Capital Asset Pricing Model (CAPM) which purports that higher risk, or higher Beta, should result in higher performance.

Lowering Risk on a Trading System

Let's get back to the trading system discussed earlier to see if choosing stocks of lower volatility could have helped. At Portfolio123 there are various ranking systems inspired by famous investors. The one I will test is called " All-Stars: Oneil".

My first step is to scan the Russell 3000 index for stocks ranking in the upper one percent of the O'Neil inspired system. Every 4 weeks the portfolio is reexamined to ensure that the highest ranked stocks are held.

CANSLIM inspired ranking system by Portfolio123 Click to enlarge

Can we slightly alter this strategy to lower some of the downside risk? Instead of keeping the top one percent of highly ranked stocks, we will cast a wider net and include the top two percent. Next, we sort the highly ranked stocks into two groups based on volatility. The group with the lower volatility will be held.

William J. O Click to enlarge

Doing so improves our overall return, although that wasn't necessarily our objective. But it also lessens our maximum loss during the bear market and improves Standard Deviation.

About half of the tickers are common to both portfolios (high and low volatility) and include Facebook (NASDAQ:FB), AT&T (NYSE:T), and Verizon Communications (NYSE:VZ). Any stock which does not rank well according to volatility, such as Diamond Resorts International (NYSE:DRII), is excluded from the lower volatility portfolio.

Old School Investor with New School Ideas

Perhaps you are an old school value investor who follows the ideals of Benjamin Graham. This simulation will sample the market every 3 months and hold the 25 highest ranked Graham-esque stocks in the S&P 500 (All-stars: Graham). Of course, if you were a rigid follower of Graham you would probably buy and hold for life. But for this exercise, let's assume you rebalance and replace holdings as needed on a quarterly basis.

Benjamin Graham S&P 500 Stocks Click to enlarge

Next, we widen our net to consider the top 50 Graham ranked stocks and hold the 25 names which have the lowest volatility.

Graham Inspired Stock Picks With Lower Volatility Click to enlarge

Again, we see an improvement in maximum draw-down during the bear market and the returns are less dispersed. Our risk-adjusted return also improves.

Certain holdings are common to both portfolios such as U.S. Bancorp (NYSE:USB) and Phillips 66 (NYSE:PSX). Other notable Graham holdings are found only in the lower volatility portfolio such as Apple (NASDAQ:AAPL) and JPMorgan Chase & Co (NYSE:JPM).

Summary

Low volatility investing is concept gaining an increasing amount of attention over the past few decades. Various research papers discuss this anomaly and find that its excess returns are present around the world. There are various ETFs which take advantage of low volatility premiums if you want to trade this as a single strategy style.

My recommendation, on the other hand, is to trade your existing strategy using volatility as a filter to remove certain stocks that may present additional risk. You may find that the roller-coaster lows are not as extreme and your total return may actually improve. Who knows, maybe I would still be trading small-cap high-growth stocks making breakouts if I had known about this tip back then.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.