Protecting your portfolio from market volatility

With the FTSE indexes leaping ahead in March, it would be easy to forget that investors have endured some turbulent conditions over the past six months. But while double-digit price swings have been common in some of the market's largest shares, others have been able to brush off this volatility with apparent ease. Why would that be?

Researchers have claimed for decades that some shares are simply less exposed than others to the ups and downs of the market. These are known as low-volatility stocks, and there is evidence that they not only provide a smoother ride for investors but they also tend to outperform riskier, high-volatility stocks over the long term.

Does high risk really mean high reward?

The late Professor Robert Haugen was a keen advocate of this theory and he wrote extensively about why low-volatility outperformance existed. As a critic of the concept that markets are highly efficient, he claimed that behavioral flaws were to blame for the phenomenon.

Haugen found that investors - including institutional funds - are predisposed to the idea that high risk equals high reward. Overconfident in their own stock-picking abilities, they are drawn to risky shares like a magnet. That popularity causes those shares to become over-priced. By contrast, lower risk stocks can become cheap, and while they are slower to rise in bull markets they don’t fall as far in bear markets.

How to tell if a stock is low risk

Calculating risk in the stock market is not simple. But one of the measures used in the study of volatility is something called Beta. This is a direct measure - often taken over several years - of how sensitive a stock price is to the movement of the wider market.

If a stock's price tends to rise more than the market on up-days and fall more than the market on down days, it will have a Beta greater than 1. But if it isn't as sensitive to market movements, rising, or falling, less than the market, then it will have a Beta of less than 1. It wouldn’t give you the full picture of volatility, but it can be used as a risk indicator to show how exposed your portfolio is to riskier stocks.

Stockopedia created a screen for Interactive Investor that looks for FTSE 350 shares with a Beta of less than 1. We then sorted it for those with the best overall combination of quality, value and momentum factors - which we call StockRanks. We also added a red flag indicator in the form of the Altman Z-Score, which weeds out stocks with any hint of bankruptcy risk.

The screen picks up stocks ranging from blue chip stalwart Imperial Tobacco, through to mid-cap food producer Cranswick, which has the lowest Beta here at 0.24. The one year price performance has been positive across the board. Most have beaten the FTSE 350 return of 6.5%, although food wholesaler Booker is still recovering from a poor performance in 2014, as is Britvic. High street bakery chain Greggs, with a Beta of 0.43, has easily produced the best return, at 105%. Gaming and entertainment company Rank has the highest StockRank, at 99 (out of 100).

Despite being studied for many years, the low-volatility anomaly has generally remained under the radar. Only recently has it emerged as a hot topic as investors have turned their attention to reducing portfolio risk. Understandably, that has sparked a debate about whether the phenomenon can be (or is being) arbitraged away. If that were the case, these apparently lower risk shares would become more expensive as their popularity increased. Yet if Robert Haugen's convictions are correct, the emotional drivers that lead many investors to chase "lottery ticket" stocks mean that this anomaly won't disappear anytime soon.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ed Page Croft of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

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It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

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About the author

Ben Hobson is Strategies Editor at Stockopedia.com. His background is in business analysis and journalism.

Ben writes regularly on investment strategy performance and screening ideas for  Stockopedia. He is the author of several ebooks including "How to Make Money in Value Stocks"