The Volatility Effect: Lower Risk Without Lower Return
23 Pages Posted: 17 Apr 2007
Date Written: July 4, 2007
We present empirical evidence that stocks with low volatility earn high risk-adjusted returns. The annual alpha spread of global low versus high volatility decile portfolios amounts to 12% over the 1986-2006 period. We also observe this volatility effect within the US, European and Japanese markets in isolation. Furthermore, we find that the volatility effect cannot be explained by other well-known effects such as value and size. Our results indicate that equity investors overpay for risky stocks. Possible explanations for this phenomenon include (i) leverage restrictions, (ii) inefficient two-step investment processes, and (iii) behavioral biases of private investors. In order to exploit the volatility effect in practice we argue that investors should include low risk stocks as a separate asset class in the strategic asset allocation phase of their investment process.
Keywords: alpha, strategic asset allocation, volatility, volatility effect, low risk stocks, CAPM, Fama-French factors, international
JEL Classification: M, G3, H54
Suggested Citation: Suggested Citation