The Boring Stocks That Quietly Beat the Exciting Ones
Finance theory says riskier stocks should earn higher returns. The low volatility anomaly is the stubborn finding that calmer stocks have often done better, which should not happen.
The Result That Should Not Exist
A foundational idea in finance is that risk and return go together: to earn higher returns, an investor must take more risk. Riskier stocks, those with more volatile prices, should therefore deliver higher returns to compensate for the greater risk.
The low volatility anomaly is the persistent empirical finding that this is not what happens. Portfolios of low volatility stocks have often matched or beaten portfolios of high volatility stocks, while experiencing smaller swings. Investors in the calmer stocks got more return for less risk, which the theory says should be impossible.
The theory says more risk earns more return. The data says the calmest stocks often earned the most. When the data contradicts the theory this durably, the theory is missing something.
Why It Is So Puzzling
An anomaly this large and durable should be arbitraged away. If low volatility stocks offer better risk adjusted returns, investors should pile into them, bidding up their prices until the advantage disappears. That it has persisted for decades demands an explanation for why investors do not simply exploit it.
The explanations fall into two groups: reasons investors are drawn to volatile stocks despite their poor returns, and structural constraints that prevent the anomaly from being arbitraged away.
Why Investors Overpay for Volatile Stocks
Several behavioural tendencies push investors toward volatile stocks, supporting their prices and depressing their returns.
| Tendency | Effect |
|---|---|
| Lottery preference | Investors overpay for the small chance of a big win |
| Overconfidence | Investors chase exciting stocks they think they understand |
| Attention | Volatile stocks are in the news, drawing buyers |
Volatile stocks resemble lottery tickets: a chance of a spectacular gain. Investors systematically overpay for that chance, just as they overpay for lottery tickets, which pushes the prices of volatile stocks up and their future returns down. Meanwhile boring low volatility stocks attract little attention and less demand, leaving them cheaper and their returns higher.
The Leverage Constraint
The structural explanation is more subtle and perhaps more important. Many investors want higher returns but are restricted from or unwilling to use leverage, borrowing to amplify returns.
An investor who cannot use leverage but wants higher returns has one option: buy riskier stocks, which offer higher returns without borrowing. This creates persistent demand for high volatility stocks from investors reaching for return without leverage, supporting their prices.
An investor who could use leverage would instead buy the low volatility stocks, which offer better risk adjusted returns, and lever them up to reach the desired return. But because many investors cannot or will not do this, the low volatility stocks stay cheap and the anomaly persists. The constraint on leverage is what prevents the anomaly from being arbitraged away.
How It Is Exploited
The anomaly gave rise to low volatility investing strategies that deliberately hold the calmer stocks, aiming to capture market like returns with less risk. These became popular products, marketed as a way to stay invested with smaller drawdowns.
Their popularity introduced a risk of its own. As money flowed into low volatility strategies, the previously cheap stocks became less cheap, which could erode the anomaly. Crowded low volatility stocks also became vulnerable to sharp reversals when the crowd rushed out, and there have been episodes where these supposedly safe stocks fell sharply because too many investors held them for the same reason.
The Bottom Line
The low volatility anomaly is the durable finding that calmer stocks have often earned as much as or more than volatile ones, contradicting the basic risk return tradeoff. It persists because investors overpay for volatile lottery like stocks while shunning boring ones, and because constraints on leverage force return seeking investors into risky stocks rather than into levered safe ones. The anomaly can be exploited by holding the calm stocks deliberately, though its own popularity risks crowding it and setting up sharp reversals in the stocks everyone bought for safety.