Reward for risk: how much it costs to run away from volatility
Intuitively, it may seem that for the long-term investor, the best companies are those that consistently make money by selling basic necessities to people, whether the economy is growing or declining. However, a recent article published by the U.S. National Bureau of Economic Research shows that the market is taking a toll on that psychological comfort. Issuers whose businesses are more dependent on the state of the economy have historically generated higher returns than securities of companies with stable earnings.
As believed
The authors of the study used data from the Livingston Survey of the Federal Reserve Bank of Philadelphia. This is a survey of professional economists that has been collecting expert expectations on GDP growth, inflation and other indicators twice a year since the early 1950s. This data series has helped determine the state of the economy "through the eyes of contemporaries" over the past 75 years. If the forecasts went up, it means that the market was expecting an acceleration of the economy, if they went down, then on the contrary, a slowdown was built into the current market models of the time.
The researchers then assembled one model basket of "pro-cyclical" stocks and another of "protective" stocks and calculated how much the "hold pro-cyclical and sell protective" strategy would earn. It turned out that, on average, it yielded about 1.7 to 4.4 percentage points more in each six-month period than the reverse combination. In other words, betting on more volatile securities turned out to be more profitable.
- "Procyclical" stocks are stocks of companies whose profits rise and fall with GDP. In the phase of economic recovery, sales of cars and household appliances increase, mortgages and loans are issued more actively, investments in construction and equipment increase, tourism and entertainment grow. In a recession, all of this shrinks noticeably, so a change in the economic cycle for this class of stocks means increased volatility. - "Countercyclical" or "defensive" stocks are stocks of companies whose products are always needed. Crisis or boom, people continue to buy food and basic consumer goods, turn on the lights, heat and shower their homes, get medical treatment, and pay for insurance. The key characteristic of such securities is more stable earnings, less volatility of quotations and often regular dividends. That is why they are perceived as a convenient tool for those who want to smooth out portfolio drawdowns in a crisis.
Is it true that defensive stocks always lose?
No, not always. A study by Narden Baker and Robert Haugen using data from 33 markets over 1990-2011 shows that portfolios of low-volatility stocks, on average, produced higher returns than high-volatility ones.
Index data supports this: according to Neuberger Berman calculations, from December 1990 through January 2017, the S&P 500 Low Volatility Index showed about 11% annualized returns versus 10% for the regular S&P 500.
But in a fresh stretch from Ma 2015 through October 2024, the opposite is true: The Evidence-Based Investor estimates that the standard S&P 500 rose an average of 14.3% per year during that period, while its low-volatility version yielded only 9.5%.
So defensive stocks sometimes win, but these wins are largely the result of the choice of time horizon for analysis. If there is a major market correction, there is a higher probability that the defensive strategy will show relatively higher returns. From 1990 to 2011 there were six global crises, which explains the high performance of low-volatility stocks.
Why do investors love "protection"?
In terms of classical theory, an investor should only look at long-term average returns and risk. In reality, most people live with much shorter horizons. Research by Shlomo Benartzi and Richard Thaler, who formulated the concept of "loss aversion," shows: investors evaluate portfolio outcomes too often and react much more strongly to small short-term losses than to potential long-term gains. So from a psychological perspective, it is not surprising that stocks with lower volatility seem to be the "right" choice, even if they make less money.
Another important factor is the memory of crises. After the crash of 2008 and the shock of 2020, investors around the world looked en masse for ways to "avoid the next collapse." According to various estimates - 1, 2, 3, 4 - the volume of assets in low volatility strategies grew from tens of billions of dollars in the early 2010s to about $300-400 billion by the early 2020s. That is, in fact, a separate class of products has emerged that sells not so much profitability as a sense of security. When millions of clients are willing to pay for this feeling, the future profitability of protective shares naturally falls.
Finally, simple human emotions come into play. In times of turbulence, news, social media feeds and brokerage applications increase anxiety. A portfolio with a lot of "utilities" and FMCG giants looks psychologically more comfortable than a set of cyclical companies whose quotes fly by tens of percent. The investor pays a premium for the opportunity to "sleep easy" - but that premium is subtracted from his future returns. This is exactly what the NBER captures: over the long haul, the market rewards not those who have minimized volatility, but those who are willing to tolerate cyclical cash flows for the sake of higher average returns.
In lieu of conclusions
Risk is a noble endeavor. High volatility in cyclical stocks is a feature, not a bug. The market is efficient: it only pays for risk. Stocks that "grow with the economy" make more money precisely because they are scarier to hold when the economy is down.
Do not confuse comfort and profitability. Protective stocks are useful, but their task is not to overtake the market, but to psychologically help you not to "break" in a crisis. If you have a long horizon and a disciplined replenishment strategy, the excessive bias toward "utilities," insurers, and "dividend aristocrats" means that you are simply giving away part of the growth premium to those willing to hold more pro-cyclical businesses.
The cycle premium does not invalidate fundamental analysis. The fact that pro-cyclical securities, on average, generate higher returns does not mean that any bank or construction company will automatically be your best investment. Within each asset group, the usual rules of thumb still apply: debt load, management quality, multiples valuation, competitive advantage. Plus there are sector differences in each new historical reality. So it's safer to buy a broad index or ETF covering different sectors that grow with the economy.
This article was AI-translated and verified by a human editor
