Last week I introduced ETFs that offer some hope to turbulence-scarred equity investors. It really is possible to reduce volatility, and the amount of return we have to sacrifice may not be nearly as much as theorists would lead you to expect. Today, I’ll go a step further and build, step by step, an actionable low-volatility Smart Alpha stock strategy you’ll be able to follow for free in the Portfolio123 Ready-to-Go platform.
Why Not Stay on the Sidelines
That is a perfectly fair question. If equity-market risk is inconsistent with your situation, then by all means don’t let anybody talk you back into the stock market. But I would urge that whatever decision you make, you do so in a realistic context. It’s easy to envision getting out in times of stress expecting to jump back in when conditions are right. Accomplishing that is much more difficult. Stock prices discount future expectations. That means you’ll need to re-enter the market when panic remains the order of the day. If you wait for the “right” time, you’re likely to find yourself standing at the terminal looking sadly at a now-empty gate while the flight you missed is settling into cruising altitude. So either way, one’s stance regarding equities should be about a thoughtful consideration of risk and reward, not dreams of timing wizardry.
The Case For Low Volatility Stocks
These are for those who believe in and want exposure to the equity markets, not merely on a trading basis but due to general conviction regarding the asset class, the mega-trend package consisting of population growth, rising standards of living, productivity and education, the resulting rising economic activity and profits, and finally, rising share prices (something that can even happen as interest rates rise if those increases are offset by rising profits).
Mega-trends make for fabulous rah-rah talk. If only we could just ignore 2000-02, 2008, August 2015, etc. We can’t. But if we can find a way to better position ourselves to benefit form mega-trends while doing a tolerable job of making the occasional calamities a bit less calamitous . . . that might work. Today, I’ll try to provide a sense of what’s possible (and an implementation for those who so choose).
The Low-Volatility Secret Sauce
You may be aware of Beta, the numeric measure of volatility relative to the market. It’s useful in evaluating portfolio performance, but it’s an erratic-at-best and sometimes horrendous tool for telling you how much relative volatility a particular stock is likely to experience in the future. That’s because Beta is computed solely on the basis of historic share price data. It pretends volatility is a statistical phenomenon.It’s not. Stock volatility (relative to the market) is the end result of various company characteristics, generally related to the volatility of the profit stream (which in turn, is influenced by the nature of the company’s business, its size (i.e. how internally diversified its operations can be), its balance sheet (more debt means more interest expense and hence a more volatile net-income stream), etc.
Regardless of a company’s fundamental profile, oddball things can and do happen. So it’s possible for very stable companies to have very high betas, or even for the most speculative barely-surviving companies to have very low, or even negative betas (as often happens if the stock bounces around wildly, but in ways that don’t correspond to or may even be negatively correlated with the overall market – recall that beta measures volatility relative to the market). Since, as I discussed in my last post, past performance really, truly and genuinely is not predictive of future outcomes, relying on stock price trends from the past cannot justify assumptions about future volatility – unless we do something designed specifically to support future assumptions. That’s what this model is all about.
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