What is low volatility investing?

11 September 2023 by National Bank Direct Brokerage
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Worried about a change in the market or an economic downturn? Certain stocks are considered more stable and have lower volatility because their share prices aren't as negatively affected by shifts in the market. Low volatility investing can be a great strategy for risk averse investors who want to participate in the market.

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What is low volatility investing?

Low volatility investing is a strategy where investors seek out securities that are more stable and less susceptible to market fluctuations. Volatility in this context refers to share price fluctuations that go up or down. Low volatility securities are stocks that have a history of generating steady and stable annual rates of return over the years.

A low volatility investment strategy aims to create a diversified portfolio that captures as much of the possible gains, or upside, as possible when the market is doing well. It also limits the potential losses, or downside, when valuations in the stock market decrease.

How does low volatility investing work?

Low volatility investing works by assessing the volatility of individual stocks and minimizing significant negative shifts in portfolio value while trying to generate positive returns. Investors have to look for companies that generate stable earnings and consistent dividends.

Typically, these are companies that have a track record of steady financial performance and therefore a lower likelihood of experiencing significant fluctuations in the value of their stock. They are also companies that often have lower debt and a more predictable business model, which makes them less risky investments. When searching for such securities most investors will also include the stocks Beta as a criterion in determining low volatility.

What is Beta?

One way to measure a stock's likelihood of going up or down in value is to evaluate its beta. Beta determines risk on the basis of a stock’s volatility. Analysts use beta to determine a stock's risk profile.

Beta compares a stock's movement to the average trend in the market and can be used to assess a stock's value. A stock with a beta of 1.0 is no more or no less volatile than the overall market.

A high-beta stock refers to any stock with a beta higher than 1.0. This means that the stock is riskier than the overall market. Investing in this stock may be riskier but it also has the potential to generate higher returns. A low-beta stock is below 1.0 and is potentially less volatile or risky compared to the overall market, but it will typically generate lower returns.

For example:

  • Stock A has a beta of 0.50 and Stock B has a beta of 2.00.
  • If the market drops by 1%, the share price of Stock A will only drop 0.50%, while the share price of Stock B will drop by 2.00%.

What defines a low volatility security?

Low volatility securities are usually companies that are market leaders in mature industries. They will generate consistent revenues and earnings over time, and their value tends to be stable even during changing economic conditions.

Companies that sell staple goods, such as grocery stores or healthcare companies, are good examples. Regardless of economic or environmental factors, people need to buy food and medicine, which is why companies operating in these sectors often have low betas and therefore lower volatility.

Why use low volatility investing?

For investors who are more risk averse, buying and holding low volatility securities in their portfolios can help them mitigate the uncertainty that results when the market corrects or shifts. Instead of investing in fixed income securities that generate lower returns, investors can use low volatility securities to benefit from the potential higher returns that equities can provide.

Low volatility strategies have increased in popularity and are a good choice for investors who want to manage risk better and achieve more consistent returns. For value investors and dividend investors, many low volatility stocks have qualities that they may be looking for when trying to diversify their portfolio. This means that they can purchase a low volatility stock that is also a value stock, with the added benefit of paying out dividends and achieving consistent returns.

How does low volatility investing perform in a bullish or bearish market?

During bull markets, where the market is growing, a low volatility portfolio will typically underperform compared to the general market. It is less likely that a low volatility investor will hold securities that have the potential for explosive growth but generate low to no profits – a situation that happens frequently with stocks in the tech sector, for example.

On the other hand, a low volatility investment strategy will typically outperform the general market during a bear market, when the value of securities is contracting. In these conditions, low volatility stocks often provide better protection than high volatility stocks.

At the end of the day, a low volatility investor is willing to forgo some of the upside during a bull market in order to limit the negative impact when markets start taking a turn towards lower valuations and decreased growth.

Pros of low volatility investing

  • Reduced Risk: Low volatility stocks are subject to fewer and less significant price fluctuations and as a result their value remains more stable over the long term.
  • Consistent Returns: Since the value of low volatility stocks remains more consistent over time, returns are also more stable over the long term than with more volatile stocks.
  • Diversification: Low volatility stocks can help diversify a portfolio and reduce the effects of a market downturn.
  • Risk Management: By including low volatility stocks in a diversified portfolio investors can better manage their overall risk and ensure more consistent returns over the long term.

Cons of low volatility investing

  • Short term returns: Low volatility stocks are unlikely to generate the explosive growth that high-volatility stocks are sometimes capable of. Nevertheless, some studies suggest that, historically, the slow and steady growth of low volatility stocks not only lowers risk but also generates better returns over the long term.
  • Sector Specific Risk: With low volatility stocks often concentrated in a particular sector of the economy, an unexpected downturn in that sector can have a significant effect on the value of the stock.
  • Diversification: It’s never a good idea to put all your eggs in one basket. Having a mixture of lower and higher volatility securities can create a more balanced portfolio.

To create a balanced portfolio, investors can consider typical low volatility sectors, such as utilities, staple goods and financial services. They might also include some high volatility stock and exchange traded funds in the mix, in sectors with higher betas like IT or energy. By taking a global view of their portfolio beta, investors can lean towards a low volatility investment approach by ensuring that the average beta across their diverse investment choices is at 1 or lower.

How to choose low volatility stocks?

The leading criteria used to identify low volatility stocks is a beta value under 1.0. In sectors that carry more risk, an investor could compare the beta of several companies and look for those with a lower beta than the rest.

Other important and relevant criteria to choose low volatility securities include:

  • Steady revenue and net income growth.
  • Reliable and steady earnings per share (EPS) growth. This is the rate in percent that a company's EPS increases or decreases over time.
  • A dividend-paying security that is stable or increasing based on a 5-year dividend growth rate, for example.
  • Companies with a low debt to equity ratio (D/E ratio). This is an indication of whether a company finances operations with borrowed money or by using shareholder equity.

Many critics argue that beta probably functions better as a marker of short-term rather than long-term risk. So it is important to look at some of these other fundamentals, alongside the beta, to help you make your decision when you buy a particular stock.

How to invest in low volatility stocks?

Self-directed investors can easily buy low volatility stocks on the NBDB trading platform. They can use several different tools to help them choose the type of security that fits their risk profile and investment goals.

Once investors have selected possible candidates, they can validate the securities Beta in the detailed quote section. They can purchase low volatility ETFs or investment funds for Canadian, U.S. or international equities. These investment products will generally incorporate the words low volatility into their name.

Remember that one of the advantages of purchasing ETFs is that the ETF provider does the work of selecting the individual securities, updating them, and rebalancing the pool of assets in response to changing market conditions.

Like most of us, investors tend to favor consistent returns over “random” results. That is why low volatility investing is an excellent strategy for those of us who have 9 to 5 jobs, aren't day traders, and can't dedicate their day to monitoring the markets. It's always important to remember that investing can be risky, but whatever investment strategy you choose, do your research, define your financial goals, and stick to it!

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Key Takeaways

  • Low volatility investing is an investment strategy that focuses on securities that are low risk and generate steady returns.
  • Low volatility securities are more stable and less susceptible to market fluctuations but do not benefit from explosive growth or the significant gains that can occur during bull markets or periods of significant upmarket activity.
  • Low volatility stocks have a beta lower than 1.0. High volatility stocks have a beta that is greater than 1.0.
  • Beta is an indicator that compares stock volatility or risk to the market average.
  • Low volatility securities are important to include in a robust, diversified, and balanced investment portfolio.

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