New research has found that both speculative valuations and extremely cheap stocks pose unseen risks for low volatility investors.
The research undertaken by AXA IM found that low volatility investors should avoid these ‘extreme risks’ as they add volatility to a portfolio.
The first extreme risk is speculative valuation caused by a stocks price to be significant decoupled from the fundamental attributes of the underlying company.
AXA IM found that much of this pricing inefficiency can be explained by the behavioural and cognitive flaws of investors.
AXA Investment Managers head of investments Asia Patrick Kuhner said that one theory was that people tend to blindly prefer stocks that offer a small chance of a large payoff which pushes prices up to an unjustifiable level.
“This is coupled with a tendency for people to overestimate their own ability to predict which stock will become the next ‘star’ or ‘big winner’ of the stock market,” Mr Kuhner said.
The other extreme risk came from the cheapest of stocks, specifically if those cheap stocks were based on book value which were found to lead to a deterioration in risk-adjusted returns versus the full market.
“In our view, the rationale behind this is, in general, companies that are extremely cheap are often cheap for a reason, for example they could be loss makers which are close to going out of business,” said Mr Kuhner.
Companies that were cheap on a recurring earning basis though were ones to look for said Mr Kuhner.
“It may make sense to combine these insights and avoid companies that are extremely cheap on a book value basis but maintain exposure to those that are cheap on a recurring earnings basis,” Mr Kuhner said.
The research made it clear that at either ends of the spectrum there was volatitily for portfolios that did not earn sufficient return to compensate for it, said Mr Kuhner.
“Some managers have been successful at lowering risk while also generating excess return over market cap indices by targeting exposure to the low volatility risk premia.
“However, because a naïve low volatility approach doesn’t consider valuation, low volatility investors are left exposed to these ‘extreme’ risks,” Mr Kuhner said.
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