What is low-volatility investing and how does it work? From low-volatility investing best practices to potential pitfalls, learn more with Fifth Third Bank.
In the current economic environment, volatility is the name of the game. Indices can fluctuate hundreds of points in a day. The U.S. economy is late into a growth cycle that has already lasted longer than others of its kind. Other factors—such as the ongoing trade dispute with China and a global manufacturing demand slowdown—have made Wall Street anxious about when the boom period might come to an end.
These conditions make low-volatility investments an attractive option for those looking to safe harbor stock market gains from the rally. Low-volatility investments help reduce risk and overexposure to the stock market, and can also provide a comfortable place to park investments—at least until economic conditions become a bit clearer.
How Low-Volatility Investing Works
Low-volatility investing (or a "low-beta" approach) is a simple concept at its core: pursuing investment opportunities with lower exposure to downturn than the average asset allocation. Although some stocks with more attractive valuations may be compelling investments, their strong valuations are often the residual effects of a turbulent market. That means they're susceptible to the effects of the market—whether positive or negative.
With low-volatility investing, investors look to stabilize their equity portfolios by taking advantage of lower-risk stocks. Although this may seem a counterintuitive approach—after all, higher risk yields greater reward—research shows that low-volatility investing is not necessarily disadvantageous. In fact, these stocks often outperform higher-risk options across a 10- to 15-year period. That generally makes them better investments during periods of market uncertainty.
How Corporations can Use Low-Volatility Investing
In the midst of a late boom with an uncertain future, stability is key. Reducing exposure to equities with high valuations can help protect corporates from excessive risk, and ultimately optimize portfolios for maximum long-term gains.
With a low-volatility approach, it’s about the big picture. In general, corporates can expect modest short-term gains but better long-term stability. Excluding high-volatility stocks can protect against unforeseen turbulence, leading to more stable investments that still yield competitive rates. Ultimately, this stability can create a more solvent financial future.
Why Low-Volatility Investing Makes Sense Now
In the current economy, market swings are a factor of daily life. Often, substantial fluctuations are accompanied by alarm bells of a coming downturn, and pundits start predicting an imminent recession. Although we have not seen telltale signs of a recession yet, plenty of economists say that we're "due" for a period of constriction. So it’s easy to understand why investors and corporates might feel anxious. Plus, the ever-present specter of a prolonged trade war and reduced manufacturing demand may be reason enough for businesses to park their earnings into more stable investments, even if their gains are more modest.
That's why low-volatility investment strategies make sense at this very moment. This approach to equities investments helps assuage these concerns by providing stable dividends during growth periods, and by mitigating losses during downfalls. Plus, switching to low-volatility investments now means potentially getting more favorable pricing as well, making this the ideal moment to review asset allocation.
The Potential Pitfalls of Low-Volatility Investing
It's important to acknowledge that low-volatility investing is, by definition, more conservative in nature. After all, you're pursuing a portfolio full of low-beta stocks. This strategy is not designed to deliver yields that outperform Wall Street; so, if you're looking to maximize your returns—and still have a high pain tolerance when investments dip—low-volatility investing may not be right for you.
And it’s no cure-all, either: As with any investment, you may stand to leave more on the table in terms of your results—or worse yet, still end up losing money on your investments.
Benefits Can Play Out Over Time
Still, the proof is in the numbers: If you're playing the long game in an attempt to create an environment of steady returns and a stable portfolio, low exposure—and the avoidance of high-beta stocks—will actually outperform non-conservative investments over time. Further, a more "pragmatic" approach to investing in a period of volatile market conditions may help an organization satisfy stakeholder demands.
Perhaps the most significant benefit to low-volatility investing is its relationship to an uncertain—and potentially low-growth—future. Portfolios concentrated with low-beta stocks will comparatively perform poorer than high-volatility stocks in a bull market. But when market conditions are unstable—and potentially evolve to reflect a bear market—these portfolios provide an immense upside by reducing exposure to risk. Essentially, in the case of an economic slowdown or recession, your business will be more prepared both in its equity investments and future of returns.
Low-volatility investments offer upsides—including helping to offset market queasiness—that can be particularly attractive when developing a financial strategy late into a boom cycle, as the U.S. is in now.
Knowing what low-volatility investments make sense for you and your firm can help you minimize overexposure and potentially find a more conservative (though still lucrative) play for gains made during the early portion of the current economic environment.
Your banking partner can help you determine how and when to pursue a low-volatility portfolio, as well as answer any questions you have about the strategies involved in creating one. Talk to a Fifth Third commercial banker to assess your organization’s financial risk—and find solutions that work for your long-term plan.