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How taking less risk can make you richer

Stock investors have been taken on a wild, and often disappointing, ride over the last 12 years. The period included two of the biggest bear markets in recent memory and it's no wonder why many people have simply given up on stocks.

Those that stayed in the markets are opting for more conservative stock strategies, and here's one that shows some promise: The idea behind it is to simply avoid the most volatile stocks or those with the highest betas. Doing so tends to produce portfolios that don't swing up and down as much as the market overall.

Problem is, modern portfolio theory predicts that low-beta stocks are likely to underperform the market. As a result, going the low-beta route could dampen returns. But there is more than a little evidence that you can have your low-beta cake and eat high returns too.

Before diving into the numbers, it's useful to review what beta is all about: Beta puts a number on the tendency of stocks to move in tandem with the markets. It is a mix of how volatile a stock is (or how much its returns vary) and how closely it moves (or is correlated) with the market.

Roughly speaking, stocks with a beta of one tend to move in sync with the market. Those with a beta of zero tend to move independently of the market, while stocks with high betas tend to fluctuate more than average.

Beta and volatility are separate but related things. For instance, high-beta stocks also tend to be very volatile. That's why both often produce fairly similar results when used in stock screeners.

To see how beta fares in practice I turn to Eric Falkenstein's work. In one study he tracks five stock portfolios and compares their returns to those of the S&P500. The first stock portfolio is formed by picking 100 stocks with the highest betas and the second contains 100 stocks with the lowest betas. The remaining portfolios focus on the 100 stocks with betas closest to 0.5, 1.0, and 1.5 respectively. The portfolios were rebalanced every six months and tracked from 1962 to 2010. You can review the results in the accompanying table.

How stock returns vary with beta
Beta Low 0.5 1.0 1.5 High S&P500
Return 9.7% 10.4% 10.0% 5.7% 0.6% 8.3%
Volatility (sd) 13.1% 11.7% 17.4% 26.3% 34.3% 15.1%
Source: Eric Falkenstien, 2/1962-7/2010

High-beta stocks were bad bets over the long-term. They gained only 0.6 per cent a year - 7.7 percentage points less than the market - and had a very high annual volatility of 34 per cent. On the other hand, you'd have beaten the market by about 2 percentage points annually, with lower volatility, by opting for low-beta stocks.

Given the good results generated by low-beta strategies, it should come as no surprise that they've inspired the creation of a slew of low-beta ETFs. Similar findings have also prompted the creation of low-volatility ETFs.

That's all well an good for index investors. But it also turns out that value investors get a boost by sticking with low-volatility stocks according to Pzena Investment Management.

In one study Pzena sorts the 1,000 largest stocks in the U.S. by P/B (or more technically B/P) each month from 1979 to 2010. The cheapest 200 stocks are put into an equally-weighted portfolio. Another portfolio is created by taking the cheapest 200 stocks and then removing 40 of the most volatile stocks. The performance of the value portfolio, the less-volatile value portfolio, and two indexes is shown in the accompanying table.

Low-Volatility Value in the U.S.
Portfolio Annual Return Volatility (sd)
Lowest P/B 15.1% 18.5%
Lowest P/B without volatile stocks 16.0% 16.7%
Russell 1,000 Value 11.7% 15.0%
S&P 500 11.1% 15.5%
Source: Pzena Investment Management, 1/1979 to 6/2010

Removing the most volatile stocks from the low-P/B portfolio boosted returns by nearly a percentage point annually and reduced volatility by almost two percentage points. As a result, value and low-volatility work well together.

Overall, opting for less volatile names seems to be a win-win for all sorts of investors. It's a factor that you might want to add to your investing tool kit.

First published in the Globe and Mail, October 12 2012.

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