NOTE: I sent this out to readers of my premium Green Zone Fortunes service … but my team and I decided this message about low-volatility stocks was important enough to share with everyone who reads Money & Markets. I hope you enjoy this bonus content!

One of Wall Street’s most popular maxims is: “To make higher returns, you must take more risk.”

But like many things in investing and life, that’s only a half-truth and there’s an important caveat … the low-volatility stock factor.

The maxim holds when you’re looking at major asset classes. Stocks have historically provided much stronger returns than bonds, and stocks are indeed both riskier and more volatile than bonds.

So, if you want to make the higher returns that stocks promise … you must accept their greater volatility and risk.

But when you look within the stock market, the maxim begins to break down.

You’re probably familiar with the term beta. In simple terms, it’s a measure of how volatile an individual stock is.

The entire stock market has a beta of 1.0. That’s the measuring stick: “beta = one.”

An individual stock that has a beta greater than one is more volatile than the market, and often labeled a “high-beta stock.” Think Twitter (beta = 1.63), Twilio (1.69) and Tesla (1.98).

On the other hand, stocks that have betas lower than one are less volatile than the market, and are often called “low-beta stocks.” Think Walmart (0.21), Procter & Gamble (0.31), and AT&T (0.63).

Now, I hesitate name-dropping Tesla as one example of a high-beta stock. It’s gone bonkers recently, up some 260% year-to-date!

Don’t Cherry-Pick Stocks Based on High or Low Volatility

But the important thing for you to realize about the low-volatility factor — or any factor, for that matter — is that you can’t “cherry-pick” individual stocks and determine with any degree of certainty that it will perform wonderfully (or awfully) just because it has a low (or high) beta.

Investment “factors” — whether it’s momentum, size, volatility, value, quality or growth — speak to the outperformance of those stocks in aggregate, and over the long run.

What does that mean?

It means that if you follow a disciplined process — you routinely buy stocks with low betas (i.e., less than one) while also routinely avoiding stocks with high betas (i.e., greater than one) — then, over the long run, you should expect superior performance relative to an investor who does the opposite.

It does not mean that Walmart (“low-beta”) is guaranteed to do better than Tesla (“high-beta”) … and certainly not over a short period.

Now, let me explain why the low-volatility premium is thought to exist. And then, finally, I’ll show you one of the worst types of stock you can buy — ones I’ve nicknamed “High-Beta Bombs!”

Why Low-Volatility Stocks Outperform

Many investors see small-cap stocks as riskier than large-cap stocks. That explains why an investor can earn a size premium if they’re willing to routinely invest in the stocks of smaller companies.

Meanwhile, it’s predominantly behavioral factors that explain why buying high-momentum stocks leads to market-beating returns. In short, investors routinely make “behavioral errors,” which allow us to earn a momentum premium when stocks become mispriced.

Well, with the low-volatility factor … it’s one again behavioral factors that explain why low-volatility stocks tend to outperform high-volatility stocks.

And when you think about it, it almost has to be “behavioral” factors … since in the very definition of “low-volatility,” you’re getting stocks that are less volatile and arguably less risky than high-volatility stocks!

What are these behavioral factors?

For one, there’s this factor called “limits to arbitrage,” where smart investors may want to short-sell high-beta stocks that have become unjustifiably overvalued … but they can’t actually do it, because of some restriction related to short-selling (i.e., the stock is too expensive to short-sell, or it can’t be “borrowed” from the broker — a necessity of short-selling). What’s more, some institutional funds and individual investors are simply prohibited from short-selling stocks.

So for these reasons alone, the unjustified price increases of many high-beta stocks go “unchecked” by would-be short-sellers who simply can’t make the trade.

Second, there’s a pervasive limit and aversion to using leverage. That means that a wise investor might choose to buy shares of Walmart, a low-risk, low-beta stock … and simply leverage their investment (using “margin,” or borrowed money, effectively), in order to earn a higher return.

But get this: Most investors are scared of using leverage. It’s like a “four-letter word” to many folks. So, instead of using leverage on a low-beta stock … many investors choose to buy shares of a higher-risk high-beta stock. And that leads to more demand for high-beta stocks (causing them to become overpriced) … and less demand for low-beta stocks (causing them to become underpriced).

The Lottery-Ticket Effect

Finally, there’s a third and even more interesting explanation for why many novice investors flock to high-beta stocks, even though the academic literature is clear on low-beta stocks being a better long-term choice: The “lottery-ticket” effect.

 In the words of Larry Swedroe, a foremost expert on factor investing and one of my favorite authors:

In the real world, there are investors with a “taste,” or preference, for lottery-like investments. This leads them to irrationally invest in high-volatility stocks (which have lottery-like distributions) despite their poor returns. They pay a premium to gamble. Among the stocks that fall into the “lottery ticket” category are IPOs, small-cap growth stocks that are not profitable, penny stocks and stocks in bankruptcy.

 High-Beta “Bombs” — How the Low-Volatility Factor Works

 Interestingly, the low-volatility factor works a bit differently than most of the other major factors in my Green Zone Ratings system.

With the momentum factor, for instance, you can sort stocks based on their momentum … and then assume that the Top-10% “bucket” will outperform the next-lower 10% bucket, which will itself outperform the next-lower ranked bucket … all the way down, to where the Worst-10% bucket will perform the worst of them all.

This is easiest to show with a chart. Here’s the relative performance of 10 “buckets” of stocks, based solely on the momentum factor metrics I’ve included in my six-factor Green Zone Ratings model for stocks:

Stocks “Bucketed” by Momentum

That’s how it works with momentum, and most of the other factors I look at.

But as I said, the low-volatility factor works a little differently…

You won’t necessarily earn the absolute highest return if you buy stocks with the absolute lowest beta possible. Buying stocks with low beta and average beta gives you similar returns.

Stocks to AVOID at All Costs

What’s most helpful about the low-volatility factor is the types of stocks you’ll likely want to AVOID at all cost: the highest-beta stocks.

This means that when you sort all stocks into those 10 “buckets,” based on their volatility, or beta, you want to avoid buying stocks in the worst one or two buckets (i.e., the market’s top 10% or top 20% most volatile stocks).

Over time, the horrible underperformance of the market’s 20% most volatile stocks is the biggest driver of the low-volatility factor.

This means you can consider buying roughly 80% of all stocks in the market, based on volatility alone. Just make sure you don’t buy the worst 20%, high-beta stocks. Over time, they will crush you!

What’s more, the academic research on this unique low-volatility factor tells us precisely the type of company that’s best to avoid at all cost: small, high-beta “growth” companies that are unprofitable.

I call these companies “high-beta bombs,” and I routinely run screens to make sure the companies I’m recommending are not of this type! I’ll share more on this another time.

All told, the low-volatility factor isn’t as powerful as the (favorite of mine) momentum factor. But since it can help us avoid some of the worst stocks out there, it definitely adds value from a safety perspective.

I personally don’t choose stocks based on the low-volatility factor alone. But given the choice between two stocks, which both rank highly on momentum, value, growth and quality … we can further tip the odds in our favor by choosing the one with lower volatility.

To good profits,

Adam O’Dell, CMT

Chief Investment Strategist