The recent market turbulence highlights the need for improved risk management and strategies to reduce portfolio volatility. In this post, I’ll explore how to enhance portfolio diversification using low-volatility stocks.
Gold and Low-Volatility Stocks as Diversifiers
Gold has long been regarded as a valuable diversification tool in investment portfolios due to its unique characteristics. As an asset class, gold has historically exhibited a low correlation with traditional financial assets such as stocks and bonds.
Reference [1] revisited the role of gold as a diversifier in a traditional stock-bond portfolio. It also proposed adding low-volatility stocks to the portfolio in order to reduce the risks without sacrificing the returns.
Findings
-The primary goal of investing is to avoid capital losses.
-Conservative investors often include gold in their portfolios to reduce downside risk. Although gold is volatile, it serves as a partial safe haven during bear markets.
-The study confirms that modest allocations to gold lower a portfolio’s loss probability, expected loss, and downside volatility.
-However, the downside protection offered by gold comes at the cost of reduced returns.
– In contrast, adding low-volatility stocks enhances a portfolio’s defensiveness without sacrificing returns.
-Low-volatility stocks are more effective than gold in mitigating losses while maintaining performance.
-Portfolios combining stocks, bonds, gold, and low-volatility stocks can be more resilient and allow for a higher equity allocation relative to bonds.
-The effectiveness of defensive multi-asset portfolios increases with a longer investment horizon.
In short, a stock-bond-gold allocation benefits significantly from incorporating low-volatility stocks, and the effectiveness of this defensive multi-asset portfolio grows with the investment horizon.
Reference
[1] van Vliet, Pim and Lohre, Harald, The Golden Rule of Investing, 2023, SSRN 4404688
Blending Low-Volatility with Momentum Anomalies
The low volatility anomaly in the stock market refers to the phenomenon where stocks with lower volatility tend to provide higher risk-adjusted returns compared to their higher volatility counterparts, contrary to traditional financial theories.
The momentum anomaly in the stock market refers to the tendency of assets that have performed well in the past to continue performing well in the future, and those that have performed poorly to continue performing poorly.
Reference [2] combined the low volatility anomaly with the momentum anomaly and examined whether the low volatility anomaly can enhance risk-adjusted returns in momentum-sorted portfolios.
Findings
-This paper analyzes the profitability of combining low-volatility and momentum strategies in the Nordic stock markets between January 1999 and September 2022.
-Both volatility and momentum strategies are found to remain effective as standalone (pure-play) approaches
-The authors evaluate three combination methods: 50/50 allocation, double screening, and ranking strategies.
-Among long-only portfolios, the momentum-first double screening strategy delivers the highest Sharpe ratio, slightly outperforming the ranking method.
-All long-only combination portfolios outperform the market in terms of risk-adjusted returns.
-Long-short combination strategies provide significantly better risk-adjusted returns compared to pure-play strategies.
-However, after adjusting returns using the Fama and French five-factor model, none of the combination long-short strategies outperform the pure momentum strategy.
In summary, the paper shows that incorporating both momentum and low volatility anomalies yields positive exposure to factors like value and profitability. Returns from these strategies are consistent over time and are more pronounced in later subsamples, with higher robust Sharpe Ratios. For long-only investors, the DS (double-sorted) strategy, which sorts stocks by momentum first and then by low volatility, seems superior to other strategies.
Reference
[2] Klaus Grobys, Veda Fatmy and Topias Rajalin, Combining low-volatility and momentum: recent evidence from the Nordic equities, Applied Economics, 2024
Closing Thoughts
In this post, we have seen how incorporating low-volatility stocks into a stock-gold portfolio can enhance risk-adjusted returns. We also discussed how to select stocks based on momentum and low-volatility criteria, highlighting the effectiveness of combining these factors through methods like double screening or ranking. While momentum tends to drive performance, especially in long-short strategies, low volatility adds defensiveness to the portfolio.