Minimizing Downside Risk: Quantitative Strategies for Conservative Investors

In What Works on Wall Street, James O’Shaughnessy looked at how different factors fared within individual sectors of the stock market. He found the best performing factor for the utilities sector was a composite of several factors, called “value composite 2” (VC2), and the best performing factor for the consumer staples sector was shareholder yield (SHY). Both VC2 and SHY were introduced here.

To replicate the utilities value strategy, simply purchase the top 25 stocks in the all stocks universe (market cap >$200M in 2008 $) sorted by highest VC2 score. For the consumer staples strategy, purchase the top 25 stocks in the all stocks universe sorted by highest SHY. Both strategies rebalance annually, as with all the strategies in the book.

What’s amazing about these strategies is not only do they outperform the market, they do it at a lower risk.

Strategy Performance (1968 – 2009)

Both strategies outperformed the market with lower standard deviation (see out-of-sample, 2010-2016 performance here).  A limitation of just looking at standard deviation is that it accounts for upside risk and downside risk, but since upside risk is a good thing, a more useful measure is downside deviation, which only measures downside risk.

The lower the downside deviation, the less likely the return will be lower than expected. In other words, the lower the downside deviation, the less risk the strategy has when stock prices are falling.

That’s all there is to it. If you have any questions, post them in the comments below.