5 Ways To Beat The Market In 2017 And Beyond: Part III

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In an ongoing series of articles, I have highlighted five buy-and-hold strategies that have historically outperformed the S&P 500.

Stock ownership by U.S. households is low and falling, even as the barriers to entering the market have been reduced. Improved financial literacy is a motivator for my authorship.

Investors should understand simple and easy to implement strategies that have been shown to outperform the market over long time intervals.

The third of five strategies I will revisit in this series of articles is the "low volatility anomaly" which has seen lower volatility stocks produce higher risk-adjusted returns over time.

In the mid-year review of my "5 Ways to Beat the Market," the low volatility factor tilt was the best of the five factors, outpacing the S&P 500 (NYSEARCA:SPY) by 8.5% through the first half of the year. Higher interest rates in the back half of 2016 have cut into the performance of low volatility stocks, which now have lagged the other factors over the course of the year.

Low Volatility

The Low Volatility Anomaly has been one of the topics I have most frequently authored on Seeking Alpha. Beginning in July 2015, I described a theoretical underpinning for why lower volatility stocks have historically generated risk-adjusted outperformance, behavioral explanations for the market advantage of low volatility assets, and offered empirical evidence supporting this notion across markets, geographies, and long-time intervals.

Since the groundwork behind the Modern Portfolio Theory was laid over fifty years ago, it has been axiomatic that riskier portfolios should expect to be compensated with higher returns. More recent academic research has shown that this assumption holds less well at the extremes - the least risky stocks tend to outperform the most risky stocks on both a risk-adjusted and an absolute basis.

In The Losing Trade In The Stock Market Is High Risk, I illustrated in the table excerpted below that the highest volatility decile of U.S. stocks has actually produced a negative cumulative total return over the past half century. In a related article entitled, A Trade That Never Wins And A Trade That Never Loses, I described the fact that the three lowest volatility deciles portfolios have produced the highest risk-adjusted returns, and have never produced a negative return over any ten-year period.

If we can take a subset of the broader market, low volatility stocks, and demonstrate that they have outperformed, then another segment of the market must be underperforming. Over the twenty-year plus time period we are examining, high beta stocks have fit that mold, and that absolute and risk-adjusted underperformance is captured in the graph of the cumulative returns of low volatility stocks (NYSEARCA:SPLV), high beta stocks (NYSEARCA:SPHB), and the S&P 500 below:

My favorite part of this low volatility strategy for buy-and-hold investors with a long-term horizon is that the strategy has outperformed when the stock market has been falling, besting the broader market in 2000-2002 and 2008. The low volatility strategy underperformed the most in 1998 and 1999 as tech multiples ballooned, but the strategy far outpaced the broader market in the 2000-2002 correction.

In the graph below of the returns of these three indices in 2016, low volatility stocks rallied with rates through mid-year, but high beta stocks led the way meaningfully higher post-election as the market's re-pricing of pro-growth policies of the new administration boosted these higher beta more cyclical companies.

While the Low Volatility Index will be more sensitive to higher interest rates than other segments of the equity market, I continue to expect that low volatility stocks will continue to offer attractive risk-adjusted returns over the business cycle. In my 50 Predictions for 2017, I suggested that low volatility stocks would again outpace their higher beta counterparts. I will be publishing updated results for two additional proven buy-and-hold strategies that can be replicated through low-cost indices over the next couple of days.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I am/we are long SPLV, SPY.

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.