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Sharp fluctuations this year in stocks and in the top measure of market risk present an opportunity to examine an investing concept that may provide some assurance: the low-volatility anomaly.
The anomaly is pretty straightforward: Investment researchers find that over time, higher risk doesn’t necessarily translate into higher returns.
"With the low-volatility anomaly, what we've observed is that sometimes stocks with lower volatility can keep up and sometimes even outperform stocks with higher volatility over a longer period of time," says Veronica Willis, investment strategy analyst at Wells Fargo Investment Institute. The anomaly is based on about 90 years of market research.
This concept, of course, helps underpin the universal investing advice to diversify your portfolio and plan your investments for the long term, including assets that provide steady income and don’t rise and fall abruptly with the stock market — think bonds, real estate, stocks with reliable dividends, and goods that people need even during a crisis.
To better understand the low-volatility anomaly and its significance for rocky periods in the market, let’s start with a recap on how much risk investors saw this year for the market’s near-term returns.
The CBOE Volatility Index, known as the VIX for its stock symbol, hit a 52-week high of 39 this March. Fears about market weakness shot up in late winter as stocks zagged down in reaction to the latest news developments, including the war in Ukraine, scorching inflation and federal monetary policy restraints.
The “fear gauge,” maintained by CBOE Global Markets, has since dipped into the high teens and is back up to about 34. Those factors continue to contribute to market volatility, along with worries about another potential COVID-19 surge this spring, as seen in Europe and China.
How to take advantage of the low-volatility anomaly
During market corrections, expert advisors like Willis remind people to keep the low-volatility anomaly in mind. Less volatile stocks don't fall as violently as stocks with higher volatility. While they don't make as many exciting one-day jumps, low-volatility stocks can provide steadier gains over time.
"Investors can treat stocks like the lottery and look for more volatile stocks, and they can overpay for those stocks which leads to them being overvalued and can lead them to decline,” Willis says.
But market participants are human, and humans don’t always act rationally — especially when it comes to decisions about money. Investors are therefore prone to making mistakes.