Is Low Volatility Good?

Low volatility is a concept that has been revered by some investors and dismissed by others. But let’s begin with a bold fact: low volatility can be incredibly powerful when managed correctly. It provides stability in uncertain markets, giving a sense of security when volatility spikes in the broader market. But here’s the twist—low volatility isn't always the ultimate solution, and relying solely on it can have its pitfalls. The answer to whether low volatility is "good" isn't as clear-cut as it may seem.

The allure of low volatility investments often stems from their ability to deliver consistent, albeit smaller, returns over time. Unlike high-risk, high-reward investments, these "slow and steady" strategies don't promise overnight success. But what they do offer is a measure of protection. They shield investors from wild market swings and prevent significant losses during downturns. Imagine walking on a stable bridge versus a shaky rope bridge—most people would pick stability.

However, there’s a hidden risk in focusing too heavily on low volatility: missing out on higher returns during bull markets. While high volatility often leads to dramatic price swings, it also presents opportunities for massive gains. In comparison, low volatility assets tend to underperform when the market is surging, leaving investors to question if they are leaving money on the table. But here’s where things get interesting—the secret to mastering low volatility investing lies in timing.

Understanding Volatility

Volatility, in essence, is the measure of how much an asset's price fluctuates over time. High volatility means that the price changes quickly and dramatically, while low volatility indicates more consistent price movements. Investors often use the standard deviation of returns to measure this, where lower standard deviation equals lower volatility.

Here’s the deal: In finance, risk and return are intricately linked. High risk (high volatility) often promises higher returns, but it also means there’s more potential for loss. Low-risk investments typically offer lower returns. Investors who prefer low volatility are generally seeking stability and long-term capital preservation rather than high returns.

But does that mean it's always better?

The Low Volatility Anomaly

There’s something called the "low volatility anomaly"—a counterintuitive situation where lower volatility stocks outperform high volatility stocks on a risk-adjusted basis. In theory, higher risk should come with higher rewards, but some research suggests that lower volatility investments can deliver superior long-term returns. How is this possible?

Investors sometimes flock to more volatile stocks, assuming that risk equals reward. This drives up the price of risky stocks, sometimes inflating them beyond their intrinsic value. Meanwhile, lower volatility stocks, which are often overlooked, can become undervalued, making them more attractive in the long run. This anomaly contradicts traditional financial wisdom, creating a situation where low volatility might actually be "good" in ways that aren’t immediately obvious.

Table: High vs. Low Volatility Comparison

Factor	High Volatility	Low Volatility
Risk	High risk of significant price swings	Lower, more stable returns
Potential Reward	High potential for gains (and losses)	More consistent, but lower rewards
Typical Investors	Short-term, risk-tolerant	Long-term, risk-averse
Market Sensitivity	Reacts quickly to market news	More insulated from swings
Suitability	Speculative investors	Defensive investors

Why Low Volatility Might Be Better in Bear Markets

During times of market distress, low volatility can be your best friend. Let’s take the COVID-19 pandemic as an example. While the broader stock market saw sharp declines in early 2020, low volatility stocks fared much better. Their steady returns cushioned portfolios against the chaos and allowed investors to avoid the emotional temptation to sell off their holdings at rock-bottom prices.

But here’s the catch: low volatility doesn’t mean no risk. Even these investments can decline during severe market crashes. The key advantage is that the losses are generally smaller, and the recovery is often quicker.

Balancing Low Volatility with High Volatility Investments

A balanced portfolio typically contains a mix of both low and high volatility investments. Diversification is key to managing risk and capitalizing on opportunities. High volatility assets can generate outsized returns during boom periods, while low volatility assets provide stability during downturns. In essence, it's not about choosing one over the other but rather knowing when to lean more heavily into one strategy.

Let’s look at this scenario: if you were to invest in a bull market, loading up on higher volatility stocks might be a wise decision. The upside potential can be tremendous. But, as markets peak and you start seeing signs of a downturn, shifting more of your portfolio into lower volatility assets can help preserve your gains and protect against significant losses.

Who Benefits Most from Low Volatility?

Long-term investors and those nearing retirement are particularly drawn to low volatility investments. Since these investors are more concerned with capital preservation than outsized gains, the predictable returns of low volatility assets make sense.

Institutional investors like pension funds and insurance companies also prefer low volatility strategies because they can manage large sums of money without subjecting their portfolios to excessive risk. But here’s a trick—individual investors can apply the same principles. By focusing on low volatility assets, everyday investors can mimic the strategies used by the professionals to achieve steady growth over time.

When Low Volatility Isn't Ideal

For short-term traders or those looking for quick profits, low volatility investments can feel frustratingly slow. The price changes are often minimal, and the opportunities for big wins are scarce. In these cases, more volatile assets are often the go-to for capturing short-term movements in the market.

Another downside is that in a rising interest rate environment, low volatility bonds and dividend-paying stocks might underperform. Since their returns are already low, rising interest rates make other investments, like bonds, more attractive, causing low volatility assets to become less appealing.

Conclusion: The Real Secret Behind Low Volatility

In the end, whether low volatility is "good" depends on your investment goals, time horizon, and risk tolerance. For long-term stability, it’s a great option that provides peace of mind in volatile markets. But if you’re looking for quick gains, low volatility will likely feel like a slow burn.

The real secret lies in how you integrate low volatility into your overall strategy. It’s not about avoiding high volatility altogether but about finding the right balance between the two. Like most things in life, success comes from understanding the full picture, and low volatility is just one piece of the puzzle.