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This chapter is from the book

Increasing the Risk: Maintaining a Portfolio of Somewhat More Aggressive Mutual Funds

The suggestion has been made that there is little to be gained by investing in more volatile equities (or their equivalents) rather than less volatile equities. To test this hypothesis, a study was undertaken in which the quarterly ranking and rebalancing procedure was carried forth, but this time with a portfolio of mutual funds ranked 1–7 in volatility instead of 1–5. Because the "5" group represents mutual funds that are roughly equal to the Standard & Poor's 500 Index in volatility, including the 6 and 7 volatility groups brings the total portfolio universe to roughly the equivalent of the S & P 500 Index in volatility, whereas the total 1–5 universe carries less volatility than the Standard & Poor's 500 Index.

Figure 1.6

Chart 1.6 Performance of the Relative Strength Investment Approach (1990–2003), Including Groups 6 and 7 in Addition to Groups 1–5
Rates of return for the better-performing deciles are slightly greater than rates of return for the leading deciles in the lower-volatility Group 1–5 portfolio, but risks were clearly increased for this higher-volatility universe of mutual funds. Returns were very consistent, again, with decile rank: The higher the decile group was at the start of each quarter, the better the performance.

Chart 1.6 shows the results of the study, which employs a 1–7 volatility universe instead of a less volatile 1–5 universe. Let's move right along to a tabular listing of the study results.

Investment Results of Quarterly Rebalancing (June 1990–October 2003) for Mutual Funds with Volatility Ranks 1–7 (Below to Above the S&P 500 Index)

Performance Decile

$100 Becomes

Gain Per Annum

Maximum Drawdown

First decile

$640.05

+14.7%

25.7%

Second decile

598.58

+14.2

26.1

Third decile

546.91

+13.4

27.0

Fourth decile

436.13

+11.5

33.1

Fifth decile

377.81

+10.4

37.3

Sixth decile

338.25

+9.5

39.3

Seventh decile

338.48

+9.5

39.3

Eighth decile

303.26

+8.6

39.3

Ninth decile

262.72

+7.4

38.6

Tenth decile

171.37

+4.2

44.2

The Standard & Poor's 500 Index advanced at an annual rate of 10.8% (including dividends) during this period, with a maximum drawdown of 44.7%.

Observations

Increasing the volatility range of the mutual fund universe from 1–5 to 1–7 resulted in a slight improvement in the best-performing decile (+14.7 gain per annum, compared to 14.1% for the lower-volatility group). However, maximum drawdowns for the highest-performing group increased from 20.3% to 25.7%. The average gain/risk level for the best-performing decile in the 1–5 group came to .69 (14.3% average gain, 20.2% maximum drawdown), whereas the average gain/risk level for the best performing decile in the 1–7 group came to .57 (14.7% average gain, 25.7% maximum drawdown).

Conclusion: There is little, if anything, to be gained in the long run by taking the risks associated with more aggressive stock portfolios.

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