When it comes to reducing equity risk on a standalone basis, as well as total portfolio risk in a balanced portfolio, low volatility equities – i.e., the stocks of non-cyclical companies with stable earnings whose prices aren't volatile - can play a strategic role. Investing in low volatility stocks can be an effective way for investors to de-risk their portfolios while maintaining equity exposure, even in the presence of other correlated, low-risk assets.
By substituting low volatility equities for capitalization-weighted equities (i.e., broad-based stock indices weighted by market capitalization), in whole or in part, investors can potentially achieve comparable returns over a full investment cycle with a significant reduction in total portfolio risk – a phenomenon that tends to be persistent across market, volatility and correlation regimes.
This is the core argument of a new in-depth article by TD Asset Management Inc. called De-risking Portfolios with Low Volatility Equities.
One benefit of low vol equities is that they can potentially help when diversification fails. The traditional 60/40 portfolio – which includes a 60% allocation to stocks and a 40% allocation to bonds with the aim of balancing the growth potential of stocks over the long run with the defensive properties of bonds – is built on the premise that there is a persistent negative correlation between bonds and equities. When equities go up, bonds go down, and vice versa.
But when that relationship breaks down, as it did in 2022, so do the purported benefits of diversification. The 2022 experience is a reminder that while diversifying across asset classes is necessary to reduce risk, it may not always be sufficient.
Another de-risking property of low vol equities is that they can help weather market crashes. As a standalone strategy, low volatility equities have proved remarkably resilient, consistently lowering risk and downside participation across a variety of market regimes. Low volatility equities outperformed other equity styles during the worst crises of the last quarter century.
Yet another risk-reducing property of low volatility equities is that they free up room in investors' risk budget, allowing them to hold more equities or other return-seeking assets. The article demonstrates this by examining two classic 60/40 portfolios, one using capitalization-weighted equities and the other low volatility equities.
For more detail, read the full article.
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