Low volatility investors have been warned to avoid excessively cheap stocks and the most over-valued ones, with new research from AXA Investment Managers showing extreme risks add volatility to a portfolio.
According to AXA IM’s head of investments Asia, Patrick Kuhner, while some managers have managed to find the sweet spot by targeting exposure to low volatility risk premia, given such an approach doesn’t consider valuation, low volatility investors are left exposed to “extreme risks” like speculative valuation and extreme value.
The investment firm said a stock’s valuation becomes speculative when its stock price is “significantly decouples from the fundamental attributes of the underlying company”. It said much of this pricing inefficiency can be explained by the behavioural and cognitive flaws of investors.
“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,” said Kuhner.
Kuhner said many investors target the cheapest of stocks in order to add return to their portfolio, and while he acknowledged this could be a good strategy, very cheap stocks are often cheap for a reason.
“Perhaps a more nuanced approach would be beneficial when identifying which companies are truly ‘value opportunities’ and a risk worth taking,” he said.
The investment firm said there was a difference between stocks that were extremely cheap on a recurring price-to-earnings basis, versus a price-to-book basis.
“While buying very cheap stocks based on their recurring earnings looks to have improved risk adjusted returns…buying very cheap stocks based on book value can lead to a deterioration in risk-adjusted returns versus the full market,” it said.