The Volatility Effect

There is empirical evidence that stocks with low historical volatility have high risk-adjusted returns, with annual alpha spreads of global low-versus high-volatility decile portfolios of 12 percentage points over 1986-2006. This volatility effect appears independently in U.S., European, and Japanese markets. It is similar in size to classic effects such as value, size, and momentum, and cannot be explained by implicit loadings on these well-known effects. These results indicate that equity investors overpay for risky stocks. Possible explanations include leverage restrictions, inefficient two-step investment processes, and behavioral biases of private investors. To exploit the volatility effect in practice, investors might include low-risk stocks as a separate asset class in the strategic asset allocation phase of the investment process. TOPICS: Portfolio construction, volatility measures, risk management