by What is stock market volatility? How do volatile stocks perform? How will your newfound knowledge about stock market volatility affect your investment strategy?
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Stock Market Volatility
Stock market volatility is the magnitude of difference from the mean.
You can almost think of it as seismic waves from an earthquake.
An earthquake of 1.0 magnitude will have small waves (similar to low volatility) and an earthquake of 8.0 magnitude will have large waves (similar to high volatility).
Take a look at this graph showing two different portfolios. The low volatility portfolio is shown in blue. Its highs are not so high above its lows, and its lows are not so low from its highs. The magnitude of difference from its mean is small.
On the other hand, the high volatility portfolio has much higher highs and much lower lows. It is like looking like a much more extreme earthquake.
Volatility is used somewhat synonymously with “risk”. High volatility stocks are viewed as more risky than low volatility stocks.
It is typically established that higher risk means higher reward. You’ll see later that this is sometimes, but not always true.
What is Beta?
Beta is the measure of volatility compared to the S&P 500.
S&P 500 is the baseline comparison, so it has a beta of 1.0.
A stock with a beta greater than 1.0 has a higher volatility than the S&P 500 (just known as “the market”) and is deemed to be relatively more risky. Citigroup has a beta of 1.92 and is deemed to be more risky than the market.
A stock with a beta less than 1.0 has a lower volatility than the market and is deemed to be relatively less risky.
Kimberly-Clark Corporation has a beta of 0.54 and is deemed to be less risky than the market.
Does higher volatility mean higher returns?
In theory, higher volatility means higher risk, which means higher returns.
Looking at the chart below, you’ll see that stocks have significantly outperformed bonds over the past 25 years. Stocks have higher volatility than bonds and have outperformed them.
But high volatility does NOT ALWAYS lead to higher returns. If you do a quick google search, you will find plenty of examples where a low volatility portfolio outperformed a high volatility portfolio like in the example below.
SP Global did a study that showed that the S&P 500 low volatility index outperformed the S&P. It was less volatile (thus less risky) but produced higher returns.
Does that mean you should jump into low volatility funds?
Not so fast.
I did a quick search to see what low volatility funds were available.
Invesco S&P 500 Low Volatility ETF (SPLV) fit the bill of a widely available fund that had been around about 10 years.
I was disappointed to see the results. The low volatility fund over the past 10 years had a return of 117%, which dramatically lagged the S&P which returned 180.14% over the same period. Yes, SPLV has a yield of 2% which is greater than the SPY yield of 1.5%, but I don’t think that would be enough to close the gap. As you can see on the chart, the performance of both funds was very similar up until 2020. But during 2020, stocks had an enormous bull run, where SPY saw outsized returns, while the SPLV did not.
Summary
Rule of thumb says that high volatility will bring higher returns. High risk = high return right?
Usually yes, but you can find many examples where that may not be the case.
High volatility won’t always bring outsized returns.
Low volatility won’t always bring outsized returns either.
That’s why it’s important to have a diverse portfolio based on your investment goals.
