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Low volatility strategies to help investors fend off uncertainty

Low volatility stocks can be better placed to withstand the challenges of market turmoil
storm and volatility
Some stocks can keep you out of the storm

Readers of the Stock Market Almanac may know that October is historically one of the most volatile months of the year for shares.

The reason - if you believe in seasonal trends - is that many buyers return to the market in October (after selling up in May). And while that can send prices rising, the downside is that patches of weakness can be severe.

Opinions differ on these kinds of calendar effects. But what is certain is that UK markets have flattened out in 2018 after delivering two years of very solid gains.

For those who worry about rapidly rising valuations, this hiatus could be a welcome breather.

But you could also interpret the drift in prices as a sign of creeping uncertainty about what lies in wait for equities. With Brexit looming large and President Trump’s trade war with China ratcheting up, you could argue that a lot could go wrong in the months ahead. UK markets could be in for some stormy weather.

Dealing with uncertainty

Predicting the outcome of these events is impossible of course. But one way of taking comfort and positioning a portfolio to deal with potential volatility is to look at how individual stocks tend to be buffeted by the market. Those that are less volatile could be a preferred option for investors who are worried about the impact of market uncertainty.

Over the past few years, growth and momentum have outpaced strategies like value and dividend investing.

That’s because investors flock to fast-moving stocks in up-markets. But it’s also true that speculative growth shares can suffer the most when market sentiment changes.

This means that in downturns, shares that are less sensitive to the market mood could be a safer, more predictable option.

While low volatility shares don’t tend to outperform in bull markets, evidence shows they do much better in periods of uncertainty.

In fact, over the long term, low volatility - which essentially means taking less risk - has been shown to be the superior approach.

This ‘low-vol anomaly’ was a finding of the late Professor Robert Haugen, who wrote in detail about low-volatility outperformance existed.

He concluded that it was caused by investor behaviour and that there was a misconception that high risk equals high reward.

Haugen believed that investors were overconfident in their own stock selection abilities and naturally attracted to risky shares.

As a result, these shares would become overpriced, while lower risk shares would actually become cheap to buy. And while these cheaper, low-vol stocks are slower to rise in bull markets they don’t fall as far in bear markets.

Figuring out what makes a low volatility stock

Calculating volatility in the stock market is not simple. One of the measures used is called Beta.

This is a direct measure - often taken over several years - of how sensitive a stock price is to the movement of the wider market.

If a stock’s price tends to rise more than the market on up-days and fall more than the market on down days, it will have a Beta greater than 1.

But if it isn’t as sensitive to market movements, rising, or falling, less than the market, then it will have a Beta of less than 1.

Another option is to look at a stock’s standard deviation. This is a mathematical way of understanding how much a company’s share price moves away from its average over a (three year) period.

At Stockopedia we interpret this with RiskRatings, which assign each stock a classification ranging from Highly Speculative, Speculative, Adventurous, Balanced or Conservative.

As a starting point in the search for potential low-volatility stocks, here is a low volatility screen that uses some of these low-volatility inputs in an effort to find stocks that might be better placed to weather uncertain conditions. The rules include:

-       A Beta of less than 0.8

-       The top five Balanced and top five Conservative RiskRatings.

-       Reasonable valuation, quality and momentum - a StockRank position greater than 80

-       Low bankruptcy risk (using the Altman Z-Score)

 

Name

Mkt Cap £m

Beta

Risk Rating

StockRank Style

Stock Rank™

% Price Chg 1y

Costain

452.2

0.09

Balanced

Super Stock

83

-2.97

Royal Mail

4,831

0.20

Balanced

Super Stock

99

+24.7

Avon Rubber

421.9

0.27

Balanced

High Flyer

92

+44.8

Fuller Smith & Turner

520.1

0.29

Balanced

Style Neutral

81

-7.59

Cranswick

1,731

0.37

Balanced

High Flyer

88

+13.3

Britvic

2,090

0.60

Conservative

High Flyer

86

+8.22

Smith & Nephew

12,097

0.61

Conservative

High Flyer

83

+5.05

John Laing

1,516

0.65

Conservative

Style Neutral

88

+16.9

BAE Systems

19,969

0.67

Conservative

High Flyer

82

-1.08

Croda International

6,677

0.76

Conservative

High Flyer

83

+35.1

Source: stockopedia.com

Several of the stocks passing these rules have reputations for being solid, dependable companies. Many have outstripped the market over the past year, including the likes of Avon Rubber, Royal Mail and Croda.

And while safer investment profiles can be found in large-caps like BAE Systems and Smith & Nephew, it’s also possible to get the same exposure in much smaller stocks like Costain, Avon Rubber and Fuller Smith & Turner.

So after a racy couple of years for growth and momentums stocks, 2018 has been a quieter affair.

But against the backdrop of an uncertain macro picture, there could be trouble ahead for some of the most expensive, higher-volatility stocks if sentiment in the market changes.

So it could be worth planning for how to deal with a period of uncertainty by exploring where lower volatility can be found.

Low volatility stocks are often better placed to withstand the challenges of market turmoil, which means they’re a useful way of diversifying risk in a portfolio.

 

Disclaimer: This content should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.

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