Viewpoints

January 2012
Your Global Investment Authority Charles Lahr

Stock Volatility: Not What You Might Think

The most basic concept taught in Finance 101 is the tradeoff between risk and return: Higher risk gives us the possibility for higher returns. As a bedrock principal of market relationships, this concept forms the basis of a number of landmark theories such as the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH). But practitioners need to beware as these theories may not apply exactly as written when it comes to the relationship between risk and return for individual equities. To state it concisely: If youre investing in equities, you need to know that lower risk appears to produce the potential for higher returns in the long term. (We measure risk using the periodic standard deviation of stock price returns.) To support what might be an incendiary statement for some, lets first take a look at a shorter time horizon. Over the trading period of calendar year 2010, we find that volatility and positive returns generally tend to be closely correlated. This is broadly consistent with what you would expect from Modern Portfolio Theory and the EMH. The chart below gives an example of how risk and return interacted over 12 months with an upward moving market. The general relationship implied here is that buying risk typically paid off for the investor in a period where the index was up 10.6%.

Charles Lahr, CFA Executive Vice President Portfolio Manager

Figure 1: MSCI World One-Year Return Deciles 20.0 18.0 Annual Return % 16.0 14.0 12.0 10.0 8.0 6.0 13.5 12.1 10.4 9.5 9.1 11.2 15.1 15.0 19.0

18.3

Low

Risk Decile

High

Composed of risk and return data for individual stocks segmented into risk deciles within the reference index Source: Factset 12/31/2009 12/31/2010

But volatility cuts both ways. In a market down over 20% like 2002, more risk meant greater losses:
Figure 2: MSCI World 2002 Return Deciles 5.0 0.0 -5.0 -10.0 -15.0 -20.0 -25.0 -30.0 -16.9 -18.8 -3.0 -3.9 -5.5 -8.7 -8.4 3.1 0.6

Annual Return %

Low

Risk Decile

High -28.4

Composed of risk and return data for individual stocks segmented into risk deciles within the reference index Source: Factset 12/31/2001 12/31/2002

Over a year, a stocks volatility can define its participation in the overall market. More risk tends to amplify the markets return. So obviously getting the market direction right over a 12-month horizon would likely be very important if youre making a trade. But over longer periods, our data suggest that lower volatility can lead to higher returns. Why? One reason is that when markets arent unidirectional, avoiding downside can have powerful effects on compounding.

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Consider the five-year period from December 2005December 2010. Over this time horizon, the MSCI World index returned an annualized average of 1.06% and captured both the ups and downs of a market cycle:
Figure 3: MSCI World Five-Year Return Deciles 8.0 6.0 5.6 4.0 Annual Return % 2.0 0.0 -0.1 -2.0 -2.4 -4.0 -6.0 Low Risk Decile High 3.8 3.5 2.7 3.2 1.3 1.0

-5.5

Composed of risk and return data for individual stocks segmented into risk deciles within the reference index Source: Factset 12/31/2005 12/31/2010

Here lower volatility led to higher returns. Investors simply werent compensated for taking on more risk; in fact, they were more compensated for taking less risk. Did this relationship hold over a 10-year period? Yes it did:
Figure 4: MSCI World 10 Year Return Deciles 8.0 7.5 7.0 6.4 Annual Return % 6.5 6.0 6.0 5.5 5.5 5.0 4.5 4.0 Low Risk Decile High 5.3 5.2 5.7 5.4 4.9 7.3 6.8

Composed of risk and return data for individual stocks segmented into risk deciles within the reference index Source: Factset 12/31/2001 12/31/2010

And over 25 years, with the market returning an average of 7.65% annualized, a striking relationship exists between risk and return. This should be enough for investors to reexamine their perception of risk and return:

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Figure 5: MSCI World 25 Year Return Deciles 12.0 11.0 11.0 10.0 Annual Return % 10.0 9.0 8.0 7.0 6.0 8.9 8.4 8.1 7.6 7.2 7.7 10.3 9.6

Low

Risk Decile

High

Composed of risk and return data for individual stocks segmented into risk deciles within the reference index Source: Factset 12/31/1985 12/31/2010

But the doubters who have stayed with me this long may well be thinking that the reason this relationship exists is because of the global financial crisis and corresponding losses in financials dragging down long-term returns. After all, how can modern finance be so flawed? Well answer that question, but you can see that even before the financial crisis occurred, higher volatility stocks produced lower returns over the long run:
Figure 6: MSCI World Pre-Crisis Return Deciles (1986-2007) 14.0 12.9 12.8

13.0

Annual Return %

12.0 11.0 11.0 10.2 10.0 10.5 9.7 9.7 11.1 10.7 10.3

9.0

8.0 Low Risk Decile High

Composed of risk and return data for individual stocks segmented into risk deciles within the reference index Source: Factset 12/31/1985 12/31/2007

I hope Ive convinced even the most ardent cynic that theres some merit to investing in boring, historically low volatility stocks and that low risk and higher returns is a durable relationship, at least over the long term. But theres one last area to address: emerging markets.

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What about emerging markets? How many times have you been told that emerging market stock returns are all about growth? This notion is quite common in the investment world, but the data show that its actually more about the volatility. Surprised? Here are the average annual returns of individual stocks in their respective MSCI country indexes, split into the highest and lowest deciles for a number of emerging market countries:
Figure 7: Emerging Market Equities Returns Split by Volatility Decile (Jan 2000- June2011) 30.0% 23.1% 20.0% Average Annual Return 18.9% 13.5% 9.6% 8.9% 5.0% 10.7% 6.3% 2.5% 0.0% -2.3% -10.0% Low Vol High Vol -24.4% -30.0% -8.1% -5.7% -3.5% -4.9% 6.8% 5.0% 23.8% 20.7% 21.9% 17.7% 11.1% 4.6% 1.1%

10.0%

-20.0%

Based on individual stocks in the MSCI country indexes Source: Guggenheim Global Alpha

Its straightforward that higher growth tends to lead to higher volatility. It doesnt appear to matter whether its in developed markets or emerging markets. So the data here actually refute the notion that emerging market stock returns are all about growth. Certainly, structural growth is a good thing but overpaying for it is not. Once again, we see that lower volatility can lead to higher long term return potential. Why is this relationship so hard to escape? Hint: stock market participants in every country have this one thing in common theyre all human. Why does this anomaly exist? This collection of data presents a compelling argument that higher risk generally does not result in higher returns over the long term. Not only does this fly in the face of a number of empirical finance theories, it also seems to contradict common sense. What are some other reasons for this anomaly? First, many people are naturally attracted to scenarios with the potential for high volatility and big payoffs even if they have low odds. Second, people tend to be overconfident in their ability to forecast the future and to be correct in their assessments. Forecasting and speculation may often take a major role in selecting high volatility equities. Third, there are structural factors within the investment community that can steer professional investors toward more volatile instruments and away from lower volatility stocks. Each of these three factors is
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described below. Ben Graham never played the lottery The fact that people tend to engage in speculative pursuits has a long history and can be seen in many activities. Lottery tickets are commonly used as an example to demonstrate this attribute of human behavior, but any type of bet with long odds gets the point across. Consider two payoffs: one where you have a 50% chance of making $105 and a 50% chance of losing $100 (call it the Boring Winner) and another where you have a 99.999% chance of losing $1 but a 0.001% (1 in 100,000) chance of making $10,000 (the Exciting Loser). To most people, the second bet is much more attractive than the first. But the arithmetic of these two bets clearly shows that the first bet makes more than twice what you lose in the second bet on an expected value basis:

Table 1: Bets with Long Odds

Boring Winner
Probability 50% 50% 100% Payoff $105 ($100) Expected Value $52.50 ($50.00) $2.50

Exciting Loser
Probability 99.999% 0.001% 100.00% Payoff ($1.00) $10,000 Expected Value ($1.00) $0.10 ($.90)

What does this have to do with low volatility stocks potentially producing higher returns? Many investors, just like gamblers, are looking for big money payoffs even with long odds. But the expected outcome is often negative. Many examples of this phenomenon exist. Recall the dotcom bubble where investors purchased Internet stocks that had untested business models and no ability to generate cash flow. Also, think about the U.S. housing bubble in which people took on substantial amounts of debt and flipped houses in an attempt to generate large returns. Most bets like this end in tears. This can apply to equity investing as well. Investment ideas that capture the mind with promises of huge payoffs are naturally attractive. Also, stock volatility tends to have a high correlation with growth, which has mass appeal. Lower growth stocks that are not likely to deliver the same potential upside as the more exciting names often get neglected. And herein lays one potential reason for the historical longterm outperformance of low volatility stocks: Higher volatility stocks tend to get bid up by speculators while lower volatility stocks tend to get ignored. This can create a structural anomaly where, eventually, higher volatility stocks may disappoint and be sold while lower volatility stocks may continue to tick along. Lower volatility stocks can still fall short of expectations, but the magnitude of disappointment tends to be less precisely because of the lower volatility. And what does this have to do with value investing? Ben Graham spoke to the differences in human behavior many decades ago when he penned the valueinvesting bible, The Intelligent Investor. He provides a framework that quite clearly segments legitimate investment activity, which aims for preservation of principal and a satisfactory return, from other speculative operations. I would also say that this concept can at least be applied to segmenting equities on the basis of their volatility as well. As Ive demonstrated, the evidence from decades of stock returns is that higher volatility stocks tend to fit closely with the
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definition of speculative, and low volatility stocks are the type of investments that can offer the potential for both preservation of principal and a satisfactory risk-adjusted return. In other words, low volatility names can be a natural habitat for a value investor. Of course Im right, why wouldnt I be? Another potential reason that high volatility stocks have underperformed low volatility stocks over the long term is due to the overconfidence of investors. For example, did you know that 93% of PIMCO employees believe that theyre better looking than their peers at other firms?? Its true. Keep in mind that this level is lower than the industry average. But seriously, overconfidence is well documented in human nature as well as in the investment industry. For example, many of us have read that 82% of drivers claim to be among the top 30% of safe drivers. In the world of equity investing, overconfidence often presents itself where forecasting cash flows far in the future is commonly accepted as one of the best ways to value a stock. Forecasting is often even more necessary in the case of high volatility stocks such as biotech companies that lack a viable product or with mining companies that are exploratory and have limited cash flow. And when a forecast is proved wrong, investor losses tend to be significant as the equity market reassesses the companys prospects. In many events, the company is punished with a higher cost of equity because of the markets inability to forecast the companys future. If youre detecting a degree of circularity in this, youre right. We believe markets would be more efficient and well behaved if they just acknowledged their inability to forecast from the get go, but, unfortunately, human nature gets in the way. This is unlikely to change anytime soon. Follow the money Incentives are powerful. Theyre powerful in every aspect of life from reminding a child that theres a reward for finishing his homework to creating monetary enticement for certain behaviors on the job. In securities industry vernacular, bonuses drive actions, and the scale of monetary incentives in the investment industry is large enough to be quite an influence on a portfolio manager. So fundamentally, do the incentive schemes found in the equity industry support investing in low volatility stocks given their historical outperformance? Unfortunately, the case for this isnt very strong. Outperformance of a benchmark is generally a factor that enables investors to earn big payouts, and buying high volatility stocks sometimes produces this outcome over a short period of time. Think of the bonus as a call option: A wider distribution of outcomes makes you more likely to be in the money and higher volatility stocks tend to create the wider distribution. Put another way, imagine that you have two stocks, one thats 30% less risky than your benchmark and another one that has the potential to produce 200bps more return than the benchmark but with twice the corresponding volatility. Which stock is more likely to put you in the money on the bonus call option? For the portfolio manager looking for a bonus, the riskier stock would likely win out and the less risky stock would likely be left without a bid. This factor can temporarily drive higher volatility equities higher and leave lower volatility equities behind. Only by having compensation systems aligned with long term performance can this issue potentially be avoided.

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Investment conclusions For equity investors, the clearest takeaway is that for the long term investor, higher risk doesnt necessarily equate with higher returns. In fact, our data suggest that lower risk can lead to higher returns over the long term. As a result, passive investors should be rigorously examining their volatility exposures and return expectations. Correspondingly, we believe active investors should be cognizant of this relationship and consider low volatility stocks as an area to mine for long term ideas. To be sure, it can still be possible for higher volatility investing to create attractive returns. But we believe its likely to be obtained only with a very adept manager as it typically takes much more skill, analysis and effort to effectively manage a portfolio of high volatility stocks. A potentially less risky way to obtain attractive long term equity returns is with lower volatility stocks, and we believe skilled active management can add to that proposition. Finally, on the topic of low volatility stocks being consistent with value investing, recall that according to Ben Graham, a legitimate investment operation with a value philosophy should produce long-term returns as well as the return of principal. Since some low volatility equities may be priced richly, an active value philosophy can help discover undervalued investment opportunities within the low volatility universe and exclude stocks that arent a powerful combination. Ultimately, we believe an intelligent approach to both investing and understanding risk is most likely to produce the holy grail of equity investing the potential for lower risk and higher returns.

Thanks to Peter Bretschger for his assistance in this study.

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Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. 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