Volatility effect

Volatility effect is an anomaly that shows that stocks with low volatility earn high risk-adjusted returns. Low-risk stocks exhibit significantly higher risk-adjusted returns than the market portfolio, while high-risk stocks significantly underperform on a risk-adjusted basis. This effect cannot be explained by other well-known effects such as value and size.

Paper by Clarke, de Silva, and Thorley has found that portfolios, which consist of stocks with the lowest historical volatility, are associated with Sharpe ratio improvements, that are even larger than those in the minimum variance portfolios. Additionally, Li, Sullivan, and García-Feijóo in their paper, The Low-Volatility Anomaly: Market Evidence on Systematic Risk versus Mispricing have found out that the anomaly returns associated low-volatility stocks can be attributed to market mispricing or compensation for higher systematic risk. Behavioural biases among private investors may also cause the volatility effect. Private investors will overpay for risky stocks that are perceived to be similar to lottery tickets because they are in the search for high returns in an as short time as possible.

Volatility effect has been observed within the US, European and Japanese markets in isolation. Low Volatility Factor Effect in Stocks works on global large-cap stocks or US large-cap stocks. There is also a possibility of combining Momentum and Reversal with Volatility Effect in Stocks, and research shows there is volatility effect also in commodities.

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