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The concept of risk-return tradeoff is one of the most fundamental philosophies of investing. The belief that an investment with higher risk generates a higher rate of return makes sense on the surface, as investors seemingly should be compensated for taking on additional risk. But risk is not just characterized by potential gains, or “upside” risk, rather it works in tandem with “downside” risk of potential loss.
As risk increases, the possibilities of potential under- or over-performance of any particular investment widens. But is the risk juice always worth the squeeze? Or is there a way to decrease relative risk while simultaneously performing as well as a common stock benchmark? It can be emotionally challenging, and oftentimes monetarily dangerous managing risky investments with large price movements, all while seeking the highest possible return. There have been various studies arguing all sides, but the long-term investor tends to be best suited in a well-diversified portfolio of public and private assets composed of strategic weightings to equity, credit, and real assets.
There are three cornerstone pieces of information to the decision-making process when composing an investment portfolio: time horizon, overall objective/goal, and risk tolerance.
All of these points come with their own inherent risks to identify and manage, but one that usually sticks out is overall investment risk. There are two general terms to understand when discussing investment risk – volatility and standard deviation. Volatility describes the size and volume at which a stock’s price fluctuates¹. A stock with low volatility maintains a relatively stable price, while a stock with high volatility means it experiences upwards and downwards price movements quickly and steeply. A statistic used to quantify volatility is standard deviation. Standard deviation is driven by determining the variance between specific data points (i.e. stock price), then measuring those points relative to the average. The further the data points are from the mean, the greater standard deviation. What standard deviation ultimately tells the investor is how much variance in returns there has been historically. Knowing a specific investment’s standard deviation can help identify areas to diversify away risk within the portfolio.
The quest for lower volatility has become increasingly popular in the years following the Global Financial Crisis (GFC) in the late 2000’s. This is common behavior, as most investors bear the scars of failed investments, derailed retirements, and lost faith in the financial system – lingering symptoms catalyzed by the GFC. Looking ahead from this event leaves investors longing for steady positive movement, rather than feel any inkling of risk or decline. As is with just about any investment though, timing matters. Not timing the market, but time in the market. We believe that investing is a long-term plan, focused on the specific objectives of the portfolio within a given time period. Low volatility investing ignores the long-term agenda and enacts a plan relative to current, short-term assumptions.
Stripping public equity exposure of the volatile stocks truncates an investor’s allocation to that of a low risk and lower potential return spectrum. Experts within the CFA Institute have performed deep due diligence comparing low-volatility stocks vs high-volatility stocks over a 10-year period, with all results pointing to a clear outperformance by the high-volatility stocks². Where low volatility stocks consistently fail to perform is during the upside capture after a bear market, i.e. mid-2020 and 2023. When the broad market rebounds, low volatility stocks cannot keep pace with the growth. While avoiding losses is the goal, being positioned to recover in a timely manner is equally as important.
Can a low volatility allocation meet an investor’s goals? Potentially. But answering that question without first identifying the time horizon, overall objectives/goals, and risk tolerance is a setup for failure. Unsure of how to go about investing and don’t know where to start?
Our team at LGT Financial Advisors is ready to set you up for a successful wealth future. We believe equity markets are efficient, and therefore performance differentiators and volatility minimizers are allocated outside of the public equity and credit markets. Our philosophies are rooted in well-diversified portfolio construction utilizing public and private assets composed of strategic weightings to equity, credit, and real assets. We believe building a portfolio of economically diversified assets, inclusive of private alternative investments, delivers compelling returns with lower volatility. Similar to driving blindfolded, investing without a plan is a surefire way to miss expectations, rely on emotions for decision-making, and potentially end up in trouble.
¹ https://www.investopedia.com/terms/v/volatility.asp
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