How To Build A Strategy To Handle The Ups And Downs Of Market Volatility

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Includes: BT, BZLFY, DEO, DIISY, HLMAF, MRTPY, NGG, PEGRY, SNN
by: Stockopedia
Summary

Seasoned investors rightly say that short-term pain is the price you pay for owning an asset class (equities) that outperforms over the long run.

If you can live with periods of fear (of a permanent loss), then stocks offer the best long-term returns.

But not everything in the stock market is equal.

Understanding the difference can help to introduce some volatility diversification into a portfolio.

The stock market sell-off late last year was a reminder of how quickly a spell of bearish sentiment can start feeling like a full-blown rout. Go-go growth stocks were pegged back, fast momentum plays were pummelled and even high quality firms saw their prices tumble.

Seasoned investors rightly say that short-term pain is the price you pay for owning an asset class (equities) that outperforms over the long run. If you can live with periods of fear (of a permanent loss), then stocks offer the best long-term returns.

But not everything in the stock market is equal. Some shares are very sensitive to the daily ebbs and flows of sentiment, while others are unfazed by what the market is doing (beta). Some swing wildly around their long-term average prices, while others are much more settled (volatility). Understanding the difference can help to introduce some volatility diversification into a portfolio.

The low-vol anomaly

In unsettled conditions, shares that are less sensitive to the market mood have been shown to perform better. While these kinds of low volatility shares don't tend to outperform in bull markets, they can hold up much better when there's blood on the streets. In fact, over the long term, low volatility (or lower risk) stock strategies have been shown to be the more profitable approach.

This finding was originally made in research by the late Professor Robert Haugen, who claimed that the idea that "high risk equals high reward" was a misconception. He suggested that overconfident investors tend to bid up the prices of riskier stocks - which then subsequently underperform.

Haugen's conclusion has since been backed up by other studies. Betting Against Beta by Andrea Frazzini and Lasse Heje Pedersen (of the hedge fund AQR Capital), and The Value of Low Volatility by David Blitz (of Robeco) both find that low volatility is a powerful effect.

Frazzini and Pedersen found that "high beta is associated with low alpha" and that investors gravitate towards riskier stocks in the misplaced belief that they'll produce superior returns over lower-beta stocks.

How to hunt for more lower volatility shares

Calculating volatility in the stock market isn't simple. In the case of beta, it's is a direct measure - often taken over several years - of how sensitive a stock price is to the movement of the wider market. If a stock's price tends to rise more than the market on up-days and fall more than the market on down days, it will have a beta greater than 1. But if it isn't as sensitive to market movements, rising, or falling, less than the market, then it will have a beta of less than 1.

Another way is to look at a stock's standard deviation. This is a mathematical way of seeing how much a company's share price moves away from its average over a period of time. Three-year standard deviation is a core component of our Risk Ratings, which score stocks as either Highly Speculative (highest volatility), Speculative, Adventurous, Balanced or Conservative (lowest volatility).

To get an idea of the kinds of stocks passing some of the tests for low volatility, here's a screen using some of these measures. The rules include:

  • FTSE 350 & SmallCap shares

  • Only Conservative and Balanced Risk Ratings

  • A beta of less than 0.8

In addition, the list is restricted to companies with a StockRank (our ranking of each share's Quality, Value and Momentum) of more than 80. This is a nod to the fact that while risk and volatility are worth taking seriously, it's also important to consider valuation and whether the stocks display good quality and strong momentum.

Name

Mkt Cap £m

Beta

Risk Rating

StockRank Style

Price Chg 1y (pc)

Yield Rolling 1y (pc)

National Grid (NYSE:NGG)

29,252

0.78

Conservative

Style Neutral

+13.2

5.67

John Laing

1,895

0.58

Conservative

Style Neutral

+55.0

2.50

Diageo (NYSE:DEO)

72,509

0.77

Conservative

High Flyer

+21.1

2.40

Bunzl (OTCPK:BZLFY)

8,229

0.77

Conservative

High Flyer

+21.6

2.17

Smith & Nephew (NYSE:SNN)

12,612

0.53

Conservative

High Flyer

+14.0

2.10

Halma (OTCPK:HLMAF)

5,736

0.71

Conservative

High Flyer

+25.2

1.13

Direct Line Insurance (OTCPK:DIISY)

4,884

0.58

Balanced

Style Neutral

-4.16

7.98

Marston's (OTC:MRTPY)

621.3

0.45

Balanced

Super Stock

-7.28

7.74

BT (NYSE:BT)

22,564

0.71

Balanced

Super Stock

-6.82

6.66

Pennon (OTCPK:PEGRY)

3,292

0.73

Balanced

Style Neutral

+22.8

5.63

One of the interesting things about low volatility stocks is that they don't change much. When you go looking for stocks that rate well for their exposure to factors like quality, value and momentum but also have low beta, low volatility traits, the names are often familiar.

I've been running this screen since we launched the Risk Ratings in mid-2017, and firms like Smith & Nephew, John Laing, Diageo and National Grid have often been present. Many of these firms have reputations for being solid and dependable - and that reflects some strong price gains over the past year.

So after a choppy few months in the market - especially for growth and momentum stocks - it's worth considering how to diversify some of that volatility risk and opt for more predictable names. There are no certainties, and lower volatility stocks can become expensive in uncertain times. But low volatility stocks can be better placed to withstand market turmoil, which means they're a useful way of spreading risk in a portfolio.

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.