In Picking Winning Stocks, Boring is Best

FRIDAY, DECEMBER 7, 2012 

By MARK HULBERT

A study of bourses throughout the world concludes that a portfolio of "low-volatility" equities outperforms riskier alternatives.

Chances are that the stock you should be buying for your portfolio right now is one you might have passed on to an elderly relation.

In fact, the portfolios that perform the best, over time, are those that contain stodgy and uninteresting stocks that are the very antithesis of the exciting and volatile issues that get most of the financial press.

That's the main lesson to be taken from a recent study, "Low Risk Stocks Outperform within All Observable Markets of the World." Its authors are Nardin Baker, Chief Strategist at Guggenheim Partners, and Robert Haugen, a one-time finance professor who retired after three decades in academia and is now chairman of LowVolatilityStocks.com.

The researchers focused on how steady a stock was from month to month. Those with the steadiest returns were put in the "low-volatility" category; current examples include energy-producer Dominion Resources (ticker: D) and electric-utility Duke Energy (DUK).

In contrast, a stock that experiences large gyrations in month-to-month performance is put in the "high-volatility" category. Two current examples are Fleetcor Technologies (FLT) and Arena Pharmaceuticals (ARNA).

The researchers found that, in each of 33 countries' stock markets between 1990 and 2011, an investor on average would have made far more money by buying low-volatility stocks than with issues having the highest historical volatilities. And not by just a small amount, either: A portfolio that held the 10% of stocks with lowest historical volatilities did 18% per year better, on average, than the decile containing the most volatile stocks.

Note carefully that this result stands finance theory directly on its head. According to Investments 101, the riskiest stocks — which are, after all, the most volatile — should provide higher returns, on average, than the least risky issues.

What this new study shows, in contrast, is that, far from compensating investors for the countless sleepless nights, the highest volatility stocks tend to produce the worst returns. That's adding insult to injury.

To be sure, Baker and Haugen aren't asking us to throw academic orthodoxy out the window just because of one study, comprehensive as it otherwise is. They point to a series of additional studies over the last two decades, covering stock market history as far back as 1926, that have almost universally come to the same result.

While it's certainly understandable why academia might not have welcomed findings that call into question the very foundation of what they've been taught, we might wonder why real-world investors have not discovered that low-volatility stocks consistently do better than the most volatile ones. One major reason they haven't, according to the researchers, is our tendency to focus the bulk of our attention on the stocks that are volatile and exciting.

As a result, Baker told me "we tend to overpay for the most volatile stocks" — and that, in turn, leads such stocks to be poor performers.

The researchers documented this by carefully measuring the relationship between the performance of a stock and the number of stories about it that had previously appeared on the Dow Jones News Wires. Sure enough, they found a stark inverse correlation: The most volatile stocks garnered by far the most stories and produced the lowest subsequent returns.

In contrast, the least volatile stocks — the ones that consistently proceed to turn in the best returns — are so boring and uninteresting that few if any Wall Street analysts, journalists or even investment columnists are drawn to write about them.

Putting this new research into practice requires us to become conscious of the ways in which we are drawn to the exciting stocks that are in the news, and to be willing to give up our craving for excitement. Are we willing to instead invest in a stock that may hardly ever get mentioned over cocktail conversation or be the subject of any major news story?

If we are, then we can either construct a low-volatility stock portfolio ourselves or invest in an ETF that does so. It's clearly a lot less work for us to go the ETF route. The one with the largest assets in this space is the PowerShares S&P 500 Low Volatility ETF ( SPLV), which invests in the 100 stocks in the S&P 500 with the lowest volatilities over the trailing 12 months.

How would you pursue a low-volatility strategy if you wanted to purchase the individual stocks themselves? To strictly follow the researchers' methodology, you would need to rank all stocks according to their monthly volatilities over the trailing 24 months — and invest in a diversified group of stocks at the bottom of the ranking.

That's a daunting task, to be sure, though Haugen's website (www.lowvolatilitystocks.com) does do the work for you (though it will cost you $9/month).

Happy hunting for boring stocks!