Why Low Volatility Investing Doesn't Work

Low volatility investing is an irresistible lure to many. In the past weeks cracks are showing up in the model.

Low volatility works because boring, mundane, unexciting businesses with reliable income streams but low growth just slog along undeterred and are inherently better able to weather economic downturns.

Given the choice whether you could buy the local bakery for $300.000 producing an annual profit of $30K or the Mercedes dealership next to the highway for $3.000.000 with current annual profits of $300K you may well prefer the bakery.

People need to eat everyday but luxury cars don't do as well in downturns.

Then comes in the stock market.

In the early days of beta or low volatility you could identify companies that are less cyclical because they didn't have such sharp draw downs.

This got turned into a factor aka low volatility investing. The stocks with the historically more modest price moves get included in low vol ETFs.

Instead of selecting a company with a business that's resistant to recessions and otherwise hard to kill the ETF shortcuts that analysis but just relying on statistical measures of low volatility.

This buying of specifically these stocks further decreased their volatility making them even more attractive. Naturally the concept is especially popular in downturns, turning it into a self-fulfilling prophecy, at least if the premise holds up during the particular crisis at hand.

Now translate this back to buying the local businesses. At some point your neighbor figures out Mercedes cars don't always sell. Just as you are trying to buy another bakery, in a nearby town, he trumps your next bid with a $400k bid on another shop with $30k in annual profit.

Once you start buying income streams at higher multiples those investments start to show a reduced attractiveness in terms of risk/reward.

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