Rethinking Volatility

On paper, that would seem pretty simple to execute a low-volatility strategy; select stocks with low measures under Standard Deviation (the variability of a stock price) and/or Beta (a measure of variability relative to a benchmark, often the S&P 500). But what’s good on paper isn’t always good in real life. That’s because Standard Deviation, Beta, and all similar statistics are based on historic stock price data, and as we know, past performance doesn’t assure anything.

But my quibble with conventional quant risk measures goes way beyond the past-performance legal boilerplate. It’s that the boilerplate, however mundane it may seem after having encountered endless repetitions of it, is absolutely positively correct. Things change.

Whether past outcomes will persist into the future depends on whether what happened back then was based on substantive and sustainable reasons, or coincidence. Consider a stock with a five-year Beta of -0.12. This would, according to established financial theory, be a great stock for risk-averse investors to own. It has very little volatility relative to the S&P 500 and what little it has actually runs counter to the blue-chip benchmark. This penultimate widows, orphans and retiree paragon of stability is, drum roll, Royal Gold (RGLD), whose five-year returns are charted, along with those of the SPDR S&P 500 ETF (SPY) in Figure 1.

Figure 1

The math is correct. The stock did, indeed, have very little volatility relative to the S&P 500. So if you want to compete for a Nobel Prize, you should argue for inclusion of this stock in a low-risk portfolio. If, on the other hand, you refer solvency, run far and run fast.

The problem is that quant models that tell risk-fearing investors to chase stocks like this is that they are nothing more than math exercises. They do not pick up any of the factors that make a stock risky or not risky, either on its own terms or relative to the market. The factors that are relevant are those relating to the business. It’s the business that determines the profit stream, and it’s the stability of that stream that determines investor sentiment toward the stock (i.e. the PE, Price/Sales, etc.).