Last Updated on 10 February, 2024 by Rejaul Karim
In the dynamic landscape of financial markets, David Blitz and Pim van Vliet uncover a fascinating anomaly in their exploration of “The Volatility Effect.” Their empirical journey spans global markets from 1986 to 2006, revealing that stocks with lower volatility not only embrace lower risk but, counterintuitively, yield higher risk-adjusted returns.
The alpha spread, a robust 12%, persists across global, US, European, and Japanese markets. This volatility effect stands resilient, resisting explanations tethered to traditional factors like size and value. The authors propose intriguing rationales, ranging from leverage constraints to behavioral biases, to elucidate why investors may be overpaying for risk.
In navigating the practical realm, they advocate for the inclusion of low-risk stocks as a distinct asset class in strategic asset allocation, challenging conventional paradigms in the pursuit of enhanced returns.
Abstract Of Paper
We present empirical evidence that stocks with low volatility earn high risk-adjusted returns. The annual alpha spread of global low versus high volatility decile portfolios amounts to 12% over the 1986-2006 period. We also observe this volatility effect within the US, European and Japanese markets in isolation. Furthermore, we find that the volatility effect cannot be explained by other well-known effects such as value and size. Our results indicate that equity investors overpay for risky stocks. Possible explanations for this phenomenon include (i) leverage restrictions, (ii) inefficient two-step investment processes, and (iii) behavioral biases of private investors. In order to exploit the volatility effect in practice we argue that investors should include low risk stocks as a separate asset class in the strategic asset allocation phase of their investment process.
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Robeco Quantitative Investments
Pim van Vliet
Robeco Quantitative Investments
In summary, our investigation into the Volatility Effect reveals a compelling trend: stocks with lower volatility consistently yield higher risk-adjusted returns. Over the 1986-2006 period, the annual alpha spread between global low and high volatility decile portfolios reaches a substantial 12%.
This phenomenon is not confined to specific regions, as it holds true within the US, European, and Japanese markets independently. Importantly, the observed volatility effect remains unexplained by factors such as value and size, suggesting that investors may be overpaying for risk in the equity market.
Plausible explanations include leverage restrictions, inefficient investment processes, and behavioral biases. To capitalize on the volatility effect, we propose incorporating low-risk stocks as a distinct asset class in the strategic asset allocation phase, offering a practical strategy for investors seeking to enhance returns without compromising on risk.
1. What is the Volatility Effect, and what does the empirical evidence presented by David Blitz and Pim van Vliet reveal about the relationship between volatility and stock returns?
The Volatility Effect, as explored by David Blitz and Pim van Vliet, refers to the empirical finding that stocks with lower volatility not only exhibit lower risk but, counterintuitively, deliver higher risk-adjusted returns. The authors present evidence spanning global markets from 1986 to 2006, demonstrating a robust 12% annual alpha spread between low and high volatility decile portfolios. This phenomenon holds true across global, US, European, and Japanese markets, challenging conventional notions about the trade-off between risk and return.
2. How does the Volatility Effect resist explanations based on traditional factors like size and value, and what plausible explanations are proposed by the authors?
The study finds that the observed Volatility Effect cannot be explained by traditional factors such as size and value. Despite well-known effects like size and value, the low-risk stocks consistently outperform high-risk stocks. Plausible explanations offered by the authors include leverage restrictions, inefficient two-step investment processes, and behavioral biases among private investors. These factors shed light on why investors may be overpaying for risk in the equity market.
3. What practical implications and strategies do the authors suggest for investors based on the Volatility Effect, and how does it challenge conventional paradigms in asset allocation?
The authors advocate for the inclusion of low-risk stocks as a separate asset class in the strategic asset allocation phase of investors’ processes. This strategic shift challenges conventional paradigms by suggesting that low-risk stocks can enhance returns without compromising on risk. By recognizing the Volatility Effect and incorporating low-risk stocks into strategic asset allocation, investors have the potential to capitalize on this anomaly and achieve a more favorable risk-adjusted return profile.