Traders seek to find the next BIG think ala Apple, Bidu and co. Often times this desire is founded by the underlying assumption that taking higher risk is rewarded with higher returns. Furthermore many traders believe in an efficient market where as one can outperform the market only by taking above average risk. However this hasn’t been the case for the US stock market over the last couple of decades or so. A lot has been written about the low-volatility anomaly in financial markets. With this post I want to share some insight how this works out on index stocks over various time frames.
For my research I define risk in terms of historical volatility. I looked into S&P100 and S&P500 stocks (survivorship bias free) from Jan. 1990 until Nov. 2011. Stocks are ranked by historical volatility of various time-frames (20, 50, 100, 252 and 500 days). I tested buying the top or bottom decile (long only). So for the S&P500 index the strategy is always invested in top/bottom 50 stocks where as for the S&P100 the strategy is always invested in top/bottom 10 stocks. The test and all calculations are done using daily bars, re-ranking/rotation happened weekly. No trading cost considered.
(click on the picture to enlarge it)
Thoughts and observations
- Low volatility (low risk) outperforms high volatility (high risk) on an absolute as well as risk adjusted basis.
- The anomaly is consistent among all volatility time-frames (20,50, 100, 252 as well as 500 days).
- Buying bottom decile (low volatility) outperforms index buy and hold (without considering trading cost).
- The same test has been conducted for Nasdaq 100 stocks, with confirming results (and conclusions).
For me this is eye-opening. It refines my way of thinking about risk (and reward). Tell me what you think and how you gonna apply that to your trading (-strategies).