Forget High Risk, High Reward: Here’s Proof That Lower-Volatility Stocks Are the Best Way to Maximize Returns

By TradeSmith Editorial Staff

Listen to this post
Warren Buffett made his fortune by investing in companies with economic moats, strong fundamentals, and unrealized value. But two years ago, in a world where high-risk investments were front and center, some wondered if the Oracle of Omaha was out of touch.

In 2020, he was sitting on $140 billion in cash, his biggest buy of the year was a buyback of Berkshire Hathaway Inc. (BRK.A) shares, and BRK.A limped along to a 2% gain versus the 18% return of the S&P 500 (with dividends reinvested).

Just Google “Has Warren Buffett Lost His Touch,” and you’ll see plenty of publications with that exact headline in 2020.

Fast forward to now, and another quick internet search reveals that storylines have reverted to revering Buffett.

Buffett knows who he is as an investor — that much, he’s consistent on — and he’s not going to force himself to buy any old stock just because he has the cash waiting to be deployed.

While he may have seemed out of touch two years ago, staying true to himself always seems to work out in the long run for Buffett.

Couple that with his propensity for investing in stocks with low volatility, and you’ll have discovered Buffett’s secret to success.

This is a man with a net worth of $117 billion — a living legend — and everyday investors would do well to learn from his wisdom, especially in today’s volatile market.

Those low-volatility stocks have helped Buffett sleep at night — even during the depths of the Great Recession.

I know we could all use a little more sleep in today’s anxiety-ridden investing climate. So today, I’m going to share with you some invaluable research that will help you do just that…

Low Volatility in an Unpredictable World

Financial market researcher Crestmont Research conducted a fascinating study analyzing the volatility of the S&P 500 Index and its relation to market returns to predict outcomes from different levels of volatility.

They found that if the volatility range was in the first quartile (the lowest quartile, with a range between 0% and 1.0%), there was an 86% chance that the S&P 500 would be up for the year, with an expected return of 13.4%.

If the volatility was in the fourth quartile (the highest quartile, with a range between 1.7% and 2.7%), there was only a 40% chance the S&P 500 would be up that year, with an expected loss of 5%.

That might just seem like a bunch of numbers, but boiled down, they prove a very powerful point.

Higher volatility is connected to a higher probability of a declining market.

Lower volatility corresponds to a higher probability of a rising market.

From this study, the big takeaway for our portfolios is that we want to own low-volatility stocks. We want to assess our risk wisely and make sure that we aren’t overly invested in flashy yet fickle stocks. Now, this doesn’t mean I want to toss out everything that’s considered to have high volatility from my portfolio. Balance is key.

Rather, I want to size everything in my portfolio accordingly.

That might sound daunting, but don’t worry – with what I’m about to show you, it couldn’t be easier.

Rebalancing Your Portfolio

Ordinary investors might have to pull out a calculator and solve some equations at this point. But with TradeSmith, you have a bevy of tools at your disposal that can do the hard work for you in just a few clicks.

Let’s start with calculating risk. In TradeSmith Finance, every stock, fund, and cryptocurrency is assigned a Volatility Quotient (VQ), a number that represents the amount of volatility an asset experiences. Based on historical price data, this proprietary measure allows you to see at a glance whether one of your positions poses low, medium, high, or sky-high risk.

When you take a step back from your individual positions and look at your portfolio as a whole, you might find that you have more money in stocks that fall into the high-risk category and fewer in the low-risk category. Of course, how you choose to weight your portfolio will depend on your personal risk tolerance. But if you’re looking for a suggestion on how to shuffle around your money to avoid overexposure to exciting but unpredictable stocks, that’s where our Risk Rebalancer tool comes in.

The Risk Rebalancer takes into account the VQ of each of your positions to analyze whether you’re investing too much in high-volatility stocks and not enough in low-volatility ones. It then compensates for your natural investing tendencies by providing a recommendation of how you can allocate your money more evenly across your positions, giving you a more balanced portfolio.

This concept of distributing risk throughout your portfolio is called “risk parity,” and I’ll even show you a simple way to calculate risk parity for yourself in this May 2021 edition of Money Talks.

The Takeaway

High-volatility stocks can be exciting, but that excitement can quickly turn to despair when their turbocharged uptrends turn to downtrends on a dime.

If speculative securities are the hot rods of the market, think of low-volatility stocks as the minivans. They may not look quite as snazzy or go quite as fast, but they can still get you where you want to go — and their relative safety can help you avoid messy accidents.

But every investor’s risk tolerance is different, so tell me…What low-volatility stocks are in your portfolio right now? Are you taking any calculated risks on ones with high volatility, and if so, which?

Let me know your thoughts. While I can’t respond to everyone individually, I promise to read all of your messages.