Mitigating Left-tail Risk in Volatility Scaling: Introducing a Volatility Floor Correction

This paper studies volatility scaling, a dynamic portfolio management method that maintains portfolio volatility at a target level over time. Analysis of U.S. equity returns shows that volatility scaling can generate unintended left-tail returns, negative returns not induced by the underlying asset, but by the act of scaling itself, particularly during periods of low portfolio volatility. To address this, this paper introduces a novel correction to volatility scaling in the form of a volatility floor. Using returns data from 1962 to 2018, this study compares a buy-and-hold portfolio, a volatility scaled portfolio, and a volatility scaled portfolio with a floor correction. Results show that introducing a volatility floor correction improves the left-tail of portfolio returns. With a volatility floor correction, the expected return below the first percentile of the volatility scaling strategy improves from −0.144 to −0.120, corresponding to an improvement of 0.024 in log returns. Robustness tests across subsamples (1962–1981, 1981–2000, 2000–2018) and pre-/post-Financial Crisis confirm these findings. Finally, the analysis highlights trade-offs between improving the left-tail and capping returns when implementing the volatility floor correction.