The old saying “greater risk, greater reward” is something we have come to believe is true. Is this really true? Or can low volatility stocks actually bring better, steadier returns? To really understand how portfolio volatility can affect our investments, we need to understand what volatility is, why it matters, and how it can help mitigate your overall risks.

What is volatility?

The volatility of a stock is a measure of how widely the market price actually fluctuates. Volatility in the market can be caused by large volumes of trading, as people tend to sell in a panic or buy based on good news or the fear of missing out. This volatility is often used as a risk measurement for a stock. With a highly volatile stock, you can expect large swings in price and a greater chance of making or losing money. This means that you, as the investor, can expect an emotional rollercoaster of high highs and low lows.

What causes volatility?

Volatility in the stock market can be broken down into two main factors: the state of the economy and human psychology. There are other factors, but these are the two main ones that I will focus on. When the economic and political situation is calm, there is limited uncertainty about the future and as a result, there tends to be less volatility in the marketplace. Stocks won’t fluctuate too much as people assume things will not change too much in the future.  This is the case most of the time, but there have been times when events have caused high levels of uncertainty and volatility spikes, such as in 2020 because of the pandemic and the 2008 financial crisis. During those times of heightened uncertainty, investors panicked, selling stocks in large volumes which caused prices to fall sharply and rapidly.

Which is better: high or low?

When it comes to low volatility stocks, you need to remember that a quick return is much lower, as there are no large fluctuations in stock price. Although you might not be exposed to big winning stocks over the short term, you avoid an emotional roller coaster along the way. This also helps to prevent a substantial loss of money that may damage your portfolio beyond repair. With a loss in your portfolio, your money needs to bring in a bigger return to recover. For example, a 25% loss in your portfolio means that your other investments have to gain a net 33% to break even. Therefore, a high volatility stock that experiences a loss puts more pressure on other stocks to outperform in order to make up the loss.

Do low volatility stocks outperform?

Looking back to our original quote of “greater risk, greater reward,” can you expect a greater reward with a greater risk over the long term? Recent research (here and here) has shown that lower volatility stocks have consistently outperformed higher volatility stocks across most markets. Remember the story of the tortoise and the hare? It’s a similar thing with buying “boring” stocks at a better price rather than gambling on stocks for lottery-like payouts.  Don’t worry – a low volatility portfolio can still have high volatility stocks in them. This might seem counterintuitive, as you may think that having two or more high volatility stocks means more volatility in your portfolio, but in fact, having a few high volatility stocks may in fact help your portfolio in the long run.

How is that?

When building a portfolio, you focus on the correlation between the stocks – which means you look at how they move together. If two stocks move in opposite directions, this can lower your overall volatility, as the gain in one stock will offset the loss in another.  This is the process of diversification, with asset classes (stocks, bonds, real estate), sectors (technology, healthcare, consumables), geographic, and other factors.

In the end, having high volatile stocks that don’t work together can hurt your long term returns in your portfolio. Having low volatility stocks in your portfolio can actually generate higher returns over the long run. Remember that investing is not a sprint, it’s a marathon. It is the job of a financial planner to protect against those big losses, mitigate risk, and combine the right assets together that reduce portfolio volatility and deliver steady, safe returns.