I think it’s probable that the reason that low vol has outperformed is precisely because what you and Hans identified as the root causes of low vol are things that would naturally cause a company to outperform expectations. I intend to go into this more thoroughly in a future article.

This is Marc Gerstein’s reply:

“It’s interesting that in all the academic literature I’ve read about the reasons for the “low-volatility anomaly” nobody has come up with your and Hans’s reasoning.”

Hans and I addressed the root causes of volatility. The anomaly is a different topic. This involves, why, in a particular period of observed time, lowval outperformed, contrary to what the theoretical principles might suggest. As best as I recall, it involved performance chasing that pushed too many managers to chase highvol, causing those stocks to become too richly valued to keep going. But the very recent value inversion might have reversed than the lowvol literature I’v seen predates the recent inversion.

Ultimately, one can drive one’s self crazy with too much factor performance study. At some point, you just have to say, based on financial theory, that this is supposed to happen, data (“evidence”) be damned. If reality turns out differently, the task becomes to explain why things turned out as they did and if it didn’t play out on script, that’s a cue to search for reasons so one can figure out what to do next; simply announcing the existence of an anomaly is a great way for a professor to publish something and avoid perishing, but for investors, it’s useless (best case) or dangerous (worst case) because it misleads people. into believing the observed state of affairs is more enduring than it really is.

The term evidence-based investing is very badly misused, In law, there are many instances in which evidence is inadmissible (even if accurate). The first requirement for admissibility is relevance. But even if relevant, evidence may still be excluded if the potential inflammatory impact exceeds its probative value. Much of the quant literature I’ve seen fails the second test, and a surprising amount even botches test 1. (In this context, inflammatory should be edited to read danger of lulling readers into believing a phenomenon is more real than it really is. (The small cap effect is a huge example of literature that should never have been published based on this principle.)

Extremely wise comment, Marc. I think you and Hans Koolschijn are absolutely right and I really should have been looking at volatility from this angle all along. It’s very much like what you and I think about momentum. Stock prices reflect fundamentals and are secondary to them; judging stocks on their previous prices is never as good as judging them on their fundamentals (and sentiment signals), and looking at what prices tell us about fundamentals is more valuable than looking only at prices. It’s interesting that in all the academic literature I’ve read about the reasons for the “low-volatility anomaly” nobody has come up with your and Hans’s reasoning. That’s no excuse for me not thinking about it, though–call it a blind spot. Anyway, thanks for the correction. It’s never too late to learn from an old hand.

??????? For the record, I’m the un-named individual Yuval quotes in the first paragraph and there is absolutely nothing wrong with what I said.

So there are commonalities between beta and volatility . . . well, DUH!!! Whoever said they were distinct. They are each different flavors of the same phenomenon. But as I said, and as anybody who looks at specific stocks will easily recognize if one does it enough, Beta can be misleading because it’s tempting to forget the ” . . . relative to the market thing” and draw an erroneously conclusion Indeed, the chances of error are quire high since many web sites that offer free information to investors only show Beta and don’t show volatility.

Meanwhile, Hans Koolschijn asks: “Could there be a relationship between company characteristics (for example: variability in operating margins, ROA) and variability in price?”

YES!!! ABSOLUTELY POSITIVELY. Beta, Volatility and other metrics are ethereal . . . they don’t really exist in and of themselves. They are convenient descriptions of other things that do exist. Beta and volatility are different ways to describe something that does exist — stocks that bounce around a lot as opposed to having narrow bands within which they usually trade. But no intelligent investor4 can stop there. It’s essential to understand WHY thse differences occur. Well, let’s work our way up. Stocks respond to a measure of corporate wealth generation (usually eps) and sentiment about the earnings steam (the multiple of EPS). Companies in volatile lines of business tend to have more volatile sales patterns and that reflects down to earnings. The cost structure of a company contributes to that. The larger the portion of a company’s costs that are fixed or stepped (fixed within ranges that step up or down with changes in scale), the greater the impact on the bottom line of changes in sales. Smaller companies tend to be more volatile as they suffer comparatively from diseconomies of scale. Generally, higher margin and higher ROE companies tend to be more stable. Ditto companies with stronger balance sheets. And then., we have sentiment. Increased volatility tends to send investment community heads spinning as the Street tends to over-extrapolate everything. So we have a double whammy on stock prices; volatile earnings stream and more changeable expectations leading to bouncier PEs.

This and not scatter plots, is how you need to think about volatility; whichever kind you use (but if you use Beta, be careful not to underestimate the impact of the “relative to” qualifier.

As to the historical performance of low beta stocks, its just that, a report card that happened over specific time periods in the past. But unless you understand WHY it happened, you’re exposing your jaw (and bank accounts) to Mr. Market’s fists, and BTW, in case you haven’t noticed, Mr. Market, is s sh**load smarter — and tougher — than wannabe statisticians. Yeesh! After what we’ve been through in the last mont, I’d hope nobody around would want to debate that proposition.