June 24, 2016 | by Steve Kihm CFA, Principal and Chief Economist, Seventhwave
Risk assessment can be a slippery concept. The U.S. financial market reaction to the decision of U.K. voters to leave the European Union shines a bright light on this issue.
In reaction to the “Leave” victory, investors pulled money out of every U.S. sector but one—utilities, which received net inflows, as did Treasury bonds. See chart.
If we looked at other data, examining simple stock price volatility of each sector in isolation over the long run, we would find that utility stocks actually tend to be somewhat more volatile (12.5% annual standard deviation of percentage stock price changes for the utility sector portfolio, symbol XLU) than stocks in the consumer staples (10.8% annual standard deviation, symbol XLP) and health care (12.0% annual standard deviation, symbol XLV) sectors—see Alta Vista Research, 2016 June, ETF Analyzer. But it would be incorrect to conclude using that data that utility stocks are more risky to investors than those in the less volatile sectors, for they are not in the sense that matters.
As the chart above reveals, stocks in the consumer staples and health care sectors do not provide the sort of insulation from global bad news that utilities do. It is not the volatility of the returns in isolation, but rather the net effect that combines that volatility with the correlation of those returns with returns for the broad market that is relevant in investor risk assessment. The Brexit reaction is but an extreme example of this (utilities typically have low positive correlations, in contrast to the negative reaction suggested here), but the key is that the low correlation of utility sector returns with those of the broad market means that holding utilities in a portfolio softens the blow of market downturns better than does holding the stocks from any of the other sectors, which tend to produce returns more in tandem with broad market changes. This makes utilities low-risk (not risk-free) stocks.
Those interested in learning more about the many interesting and somewhat counter-intuitive aspects of risk should refer to my new book Risk Principles for Public Utility Regulators that I wrote with Janice Beecher, Director of the Institute of Public Utilities at Michigan State University (available from Amazon).