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"Look at market fluctuations as your friend, rather than your enemy; profit from folly rather than participate in it. "
- Warren Buffet
Investors have traditionally equated volatility with risk and viewed it as unavoidable. However, volatility also affects how returns compound over time, which raises the question: Is it possible to profit from volatility? The answer is a definitive yes.
In this article, we explore the concept of volatility harvesting, or the extra growth generated from systematically diversifying and rebalancing a portfolio. In contrast to "hunting" for securities with high return potential, we use the term "harvesting" because the activity is akin to farming, where seeds are spread widely and results are patiently harvested over time. The excess return from volatility harvesting is not an expected arithmetic excess return derived from forecasting skill, security selection, or an informational advantage. Rather, it is the excess compounded return generated from rebalancing volatile assets over multiple time periods. This excess growth is available in liquid markets with assets that have volatilities greater than zero and correlations less than one. However, only investors with the discipline to trade systematically will harvest this extra growth.
We begin the article with two thought experiments to stimulate the topic and provide insight into the mathematical ideas derived in Appendix. Next, we use market data to evaluate a simple rebalancing strategy for equal-weighted portfolios of stocks in U.S. developed, and emerging markets. We also examine portfolios of stocks selected at random to show that the excess return is independent of an active stock selection process. We show that roughly half of the excess return from volatility harvesting comes from a diversification benefit and half from rebalancing.
We focus on equal weighting because of its simplicity and because it provides a clear illustration of the underlying theory. In practice, a more nuanced approach is required, one that takes into consideration liquidity, trading costs, taxes, and other frictions. In this article, we present theoretical and empirical support for volatility harvesting - the idea that, for assets that are volatile and liquid, diversifying and rebalancing creates excess portfolio growth.
THOUGHT EXPERIMENT 1: APPLE AND STARBUCKS
Assume only two stocks are available for investment: Apple and Starbucks. We selected these two stocks to highlight the...