Tuesday, May 28, 2013

A Survey of Low Volatility Theories

David Blitz and Pim van Vliet, both of Robeco, and yours truly wrote a paper outlining the various explanations for the low volatility effect, Explanations for the Volatility Effect: An Overview Based on the CAPM Assumptions. The aim wasn't to trash or champion any particular approach, though I'm sure our biases show (we aren't in lock-step on this, note Blitz here vs. my approach here, which has a subtle distinction).  As most papers on the low volatility focus on the data, often with very different motivations, we thought a paper addressing these various theories would be helpful.

In any case, we go over the following explanations:
  • Leverage constraints
  • Regulatory constraints
  • Constraints on short-selling
  • Relative utility
  • Agents maximize option value
  • Preference for skewness
  • Crash-aversion
  • one-period model
  • Attention-grabbing stocks
  • Representativeness bias
  • Mental accounting
If you are new to the literature I think its very helpful, because it has lots of references on seminal articles in the various threads, and you should be aware of what the various theories argue. As Nietzsche said, if you know the why, the how is infinitely bearable.  

1 comment:

Anonymous said...

Eric, half of these seem like begging the question to me.

OK, so low vol outperforms because of a skewness preference...now what? You just restated the problem. The real question is what causes the skewness preference?

I, for one, prefer the relative wealth utility explanations, as they can explain a ton of other related effects (Easterlin paradox, for example) on top of low vol. And you can get a relative wealth utility model to generate a skewness preference very easily.