Tim Olson
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43 lines
2.6 KiB
Markdown
43 lines
2.6 KiB
Markdown
---
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description: "Buys low-historical-volatility stocks and shorts high-historical-volatility stocks, exploiting the empirical anomaly that lower-risk stocks deliver higher risk-adjusted returns."
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tags: [stocks, low-volatility, anomaly]
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---
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# Low-Volatility Anomaly
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**Section**: 3.4 | **Asset Class**: Stocks | **Type**: Anomaly / Low-Volatility
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## Overview
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The low-volatility anomaly is based on the empirical observation that future returns of previously low-return-volatility portfolios outperform those of previously high-return-volatility portfolios. This contradicts the naive expectation that higher-risk assets should yield proportionately higher returns, and is one of the most robust anomalies in empirical finance.
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## Construction / Signal
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Historical volatility `sigma_i` is computed from the time series of historical returns (as in the price-momentum formula):
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```
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sigma_i^2 = 1/(T-1) * sum_{t=S}^{S+T-1} (R_i(t) - R_i^mean)^2 (270)
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```
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Stocks are sorted by `sigma_i` in ascending order. A dollar-neutral portfolio is constructed by buying stocks in the **bottom decile** (low volatility) and shorting stocks in the **top decile** (high volatility).
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## Entry / Exit Rules
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- **Entry**: Buy bottom-decile stocks by `sigma_i`; short top-decile stocks by `sigma_i`.
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- **Exit**: Hold for the defined holding period (similar duration to the lookback window, typically 6–12 months).
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- **No skip period required**: Unlike momentum, no skip period is needed.
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## Key Parameters
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- **Lookback window**: 6 months (126 trading days) to 1 year (252 trading days)
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- **Holding period**: Similar to the lookback window, typically 6 months to 1 year
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- **Volatility measure**: Historical realized volatility `sigma_i` (annualized or monthly)
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- **Portfolio construction**: Dollar-neutral (long low-vol, short high-vol)
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## Variations
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- **Long-only minimum variance**: Buy low-volatility stocks only; used in minimum variance portfolio construction
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- **Beta-sorted portfolios**: Sort by market beta instead of (or in addition to) realized volatility
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## Notes
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- This anomaly goes counter to standard asset pricing theory (CAPM) which predicts higher risk = higher return.
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- Potential explanations include leverage constraints, benchmark hugging by institutional investors, and lottery preference among retail investors.
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- The lookback and holding periods are similar in duration (no skip period needed, unlike price-momentum).
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- Strategy can be combined with value or momentum factors in a multifactor portfolio (see Section 3.6).
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- Low-volatility stocks may cluster in defensive sectors (utilities, consumer staples), creating sector concentration risk.
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