Published June 22nd, 2015
There is a divide between investors on the validity of using stock price volatility to make investing decisions.
Stock price volatility measures how ‘bouncy’ a stock’s price is. The higher the stock price volatility, the more the stock price moves. Standard deviation is simply the square root of variance.
On one level, stock price volatility should not matter. The decision to invest in a business should be made based on an analysis of the business, not on an analysis on the businesses’ stock price movement.
On the other hand, stock price volatility does contain meaningful information. Businesses with stable cash flows and solid growth prospects tend to have very low stock price volatilities. Businesses with unstable cash flows and serious questions about the future tend to have high stock price volatilities.
Stock price volatility can be used as a signal to gain information about the quality of a business. Low volatility is a signal that a business generates stable cash flows.
For a business to generate stable and consistent cash flows, it very likely has a competitive advantage. As a result, low stock price volatility often signals stability and a competitive advantage.
Quantitative Versus Qualitative Analysis
Using quantitative measures to ascertain the strength of a business has both benefits and drawbacks as compared to qualitative analysis.
The biggest benefit of quantitative analysis is that it’s bias free. Johnson & Johnson (JNJ) has an exceptionally low stock price volatility. If an investor has an inherent bias against health care businesses, that investor may determine through qualitative analysis that Johnson & Johnson does not have a competitive advantage, or is weakening. Perhaps recent news articles will color analysis unfavorably.
By looking at quantitative facts about Johnson & Johnson, one can analyze the company free of biases. Johnson & Johnson is a Dividend King thanks to its 52 consecutive years of dividend increases. That is a fact, regardless of what one feels about the company. The company has a stock price standard deviation of 16.2% – one of the lowest of any business (including utilities). That is a fact as well, uncolored by previous feelings, either positive or negative, about Johnson & Johnson. Additionally, the company has increased its adjusted earnings-per-share for 31 consecutive years. Based on these facts, we can be sure that Johnson & Johnson has maintained a strong competitive advantage for a long period of time.
Another advantage to quantitative analysis is the ability to rank stocks. Johnson & Johnson has a stock price standard deviation of 16.2%, while 3M (MMM) has a stock price standard deviation of 22.5%. This goes beyond an opinion (I think Johnson & Johnson is more stable than 3M), and gives a fact (Johnson & Johnson’s stock price is more stable than 3M’s).
This is not to say that qualitative analysis has no part in investing. Rather, investors should use quantitative analysis to determine rankings and identify potential opportunities. Qualitative analysis should then be used to determine the nature and durability of a competitive advantage as well as to determine any significant road blocks to growth that may not show up in quantitative analysis.
When in doubt, however, investors should trust the quantitative approach over the qualitative approach. Numbers are concrete, opinions are ephemeral.
The Effectiveness of Stock Price Volatility
Stock price volatility is used as one of the ranking factors in The 8 Rules of Dividend Investing. A significant body of research confirms the efficacy of investing in low volatility stocks over high volatility stocks.
The table below from S&P shows the outperformance of the S&P Low Volatility Index over the S&P 500:
The S&P Low Volatility Index simply invests in the 100 lowest volatility stocks in the S&P 500. This simple portfolio has significantly outperformed the S&P 500 over long periods of time, as the table above demonstrates.
The low volatility phenomenon is observed around the world. The image below from MFS shows the returns and risk profiles of stocks around the world sorted by volatility from 1989 through 2014.
The image above shows again that stocks in the lowest two deciles of volatility tend to outperform. Keep in mind this is exactly counter to what one would expect – that high volatility stocks should have higher returns. It turns out that volatility is a better proxy for quality than for risk. The lower the volatility, the higher the quality of the stock on average.
The Persistence of the Low Volatility Phenomenon
Low volatility provides higher total returns with less ‘bumpy’ ride – due to the lower volatility. Like the momentum and value ‘anomalies’, the low volatility phenomenon is very likely to persist.
The excellent paper Why the Low Volatility Anomaly Will Persist by Eric Falkenstein explains why. The essence of the argument is that investors are competitive (in general). We seek to do better than our peers. As an example, if I averaged 15% returns a year (which is excellent), but everyone else averaged 20% a year returns, I would feel like I ‘lost’ somehow.
The drive for relative outperformance leads us to invest in higher beta and higher volatility stocks in an effort to take on more risk – and presumably more reward. Unfortunately, since most people are looking for higher returns, they over-invest in high volatility and high beta stocks, driving prices up and reducing returns. This makes low beta and low volatility stocks generate higher returns – even though they are also less risky. Since human nature is very, very unlikely to change any time soon, the low volatility phenomenon will persist.
This does not mean low volatility stocks will outperform every single year. No stock selection method or criteria outperforms every year. Over 5 or 10 year periods, low volatility stocks will likely outperform their higher volatility counterparts.