The low volatility anomaly — i.e., the tendency for low-volatility or low-beta portfolios to outperform market averages — has been the subject of at least 40 years of academic research.  Given its challenge to what “everyone knows” about risk and return, it’s a fertile field for both professors and practitioners, some of whom recently characterized “the long-term outperformance of low-risk portfolios [as]perhaps the greatest anomaly in finance.”

But anomalies, especially ones that suggest higher return and lower risk, attract investor dollars, and enough investor dollars often spell the end of anomalies.  It’s been suggested that “the low-volatility anomaly may [be]eliminated by its popularization.”

So how much popularity can low volatility stand?  Before we can suggest an answer to this question, we have to understand the source of the low volatility anomaly.  Perhaps the simplest and most intuitive explanation comes from behavioral finance, specifically from the cognitive bias that behavioral economists call the “preference for lotteries.”  Their argument is that no rational person would ever buy a lottery ticket, since the expected return of such a purchase is negative.  But billions of lottery tickets are sold all over the world every day.  Why do so many people behave in a way that classical economics can only regard as completely irrational?  The behavioral argument is that some people are willing to risk a known amount of money in exchange for the possibility, however slim, of a gigantic payoff.