The low volatility anomaly is the unexpected out performance of businesses that have lower standard deviations.
Modern portfolio theory (if anyone still follows it) dictates that volatility is a proxy for risk. Less risky investments should have lower returns.
The fact that lower volatility stocks have historically outperformed high volatility stocks is counter intuitive according to Modern Portfolio Theory.
Enter SPLV & the Dividend Aristocrats
The low volatility anomaly has given rise to several new ETFs. The largest of which is SPLV. SPLV is comprised of equal weights of the top 100 S&P 500 stocks with the lowest volatility. Many of SPLV’s holdings are also dividend aristocrats, hinting at the link between dividend aristocrats and low volatility.
The lining factor is quality. On average, a business that can increase its dividend for 25+ consecutive years is a quality business. Businesses with stable cash flows and long-term growth tend to have stable prices. They fall less during bear markets, and rise less during bull markets. This results in lower volatility.
The Low Volatility Advantage
The advantage to low volatility is hidden in the math of compound returns. A 50% loss does not require a 50% gain to recover; it takes a 100% gain to break even.
The following example shows the compounding effects of a $100 investment in 2 stocks that both have an average return of 10% over a 5 year period. Stock 2 is significantly more volatile than stock 1.
The formula to quickly estimate geometric returns from arithmetic returns is:
- Geometric Return = Arithmetic Return – (Volatility ÷ 2)
- Volatility is the standard deviation of a stock’s price squared.
Dividend Stocks Exhibit Low Volatility
Back to the link between dividend aristocrats and low volatility. 28 out of the top 100 lowest volatility stocks have increased dividends for 25+ consecutive years. 98 out of 100 pay dividends. The only 2 exceptions are (SRCE) and Berkshire Hathaway. Compare this to the S&P 500, where 84.6% of stocks pay dividends. Since its start in October of 2014, the Dividend Aristocrat ETF NOBL has had a standard deviation of 10.47% versus 9.89% for SPLV. Paying dividends results in lower volatility. A long history of dividends in particular results in lower volatility.
Why Do Dividend Stocks Have Lower Volatility?
Dividend stocks with long dividend histories have lower volatility because:
- Dividend payments result in cash distributions to shareholders, even during recessions
- A long history of dividend payments shows stable cash flows
- Long dividend history suggests a lasting competitive advantage
The reason a business can pay a dividend is the cause of low volatility in dividend stocks. The ability to pay increasing dividends over a long period of time shows stable cash flows and growth potential resulting from a competitive advantage. Low volatility is a stock prices way of suggesting that a business is of high quality.