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Most investors see volatility as risk, but these words aren't synonyms, and can be quite the opposite, says Stephen Hammers of Compass EMP Funds.

Gregg Early: I am here with Stephen Hammers, co-founder and CIO of Compass EMP Funds. Today we’re talking about volatility. Stephen, is there any great advantage to looking at volatility when buying into sectors or the market in general?

Stephen Hammers: I think it’s very important, and let me give you the reason why. When you look at stock investing, most portfolio managers might look at what they feel are the best ideas, but some of those best ideas may also be the most volatile stocks.

If you look at the S&P 500, for example, and you look at its volatility—about 84% roughly, 80% to 85% of the S&P’s return comes from the top few stocks—what that does is it dictates your return by where money is going in and out, which creates higher volatility. If most money managers don’t have those top few stocks, they can either underperform or outperform the benchmark.

We believe on taking risks to another level and managing it appropriately, where if you look at all the stocks in the stock market, you weight them based on their risk contribution. It is amazing what you can get in terms of risks and return.

Gregg Early: So it’s definitely a step beyond simple valuations, and it's an important aspect that’s overlooked by people simply looking at fundamentals.

Stephen Hammers: It’s very important. Now, fundamentals are important, because earnings drive stock prices. So in the CEMP Volatility Weighted Indexes that we created many years ago and have now had patented and published through Dow Jones, these indexes look first at if you don’t make money consistently each of the last four quarters. If you don’t have positive earnings, you don’t even qualify for the index.

That’s kind of a novel concept by itself. But once you have those stocks that qualify, they make money, and if you look at the large-cap segment of the market and you equalize the risks on all those stocks, the returns are actually quite astonishing.

Tickers Mentioned: Tickers: SPY