The stock market has boomed in the past 11 months, recovering strongly from the coronavirus bear market and producing surprising returns. Some stocks have seen their stock price double, triple or rise further with their shareholders’ optimism about the future course of their underlying businesses.
However, whenever the market goes up quickly, some investors are nervous about the impending stock market crash. To protect themselves, some of these investors rely on certain types of stocks that appear to be less volatile than the general market. But before you go out and buy a bunch of low volatility defensive stocks – or a low volatility ETF that gives you diversified exposure to a full portfolio of them – you just Tue be aware that they cannot offer complete protection against a market downturn.
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The myth of low volatility stocks
Investing in low volatility stocks became a big trend after the financial crisis of 2008 and early 2009. Investors wanted to put money in the stock market, but they did not want to be subject to the big swings that the main references like S&P 500 went through the bear markets. Instead, they hoped to find investments that would deliver solid returns, but with fewer bumps along the way.
Several ETFs have become popular in the wake of the low volatility investor movement. They included Minimum volatility iShares Edge MSCI USA (NYSEMKT: USMV) and Invesco S&P 500 Low Volatility (NYSEMKT: SPLV), which hit the market in 2011.
The stated purpose of these ETFs was to invest in stocks whose price movements were historically less volatile than the general market. As iShares said, these stocks have “potentially less risk” and, historically, these stocks have fallen less than the general market during crises.
However, when the coronavirus bear market hit early 2020, all of the old rules were reversed. As a result, low-volatility stocks failed to live up to the expectation that they would suffer less dramatic strikes than their high-volatility peers:
SPLV data by YCharts.
What happened?
The problem with looking at history when proposing an investment strategy is that history is not always repeated. In the case of the bear market, a year ago, conventional wisdom about which stocks would perform well proved to be completely wrong.
At the end of the day, many highly volatile, high-growth technology stocks performed better in the stock market. The COVID-19 pandemic has made these companies essential because of their ability to allow companies to make a rapid digital transformation to adapt to public health measures, such as closing and closing companies.
In contrast, many traditionally defensive industries did not do so well. Financial stocks, for example, suffered as the threat of high unemployment forced banks to dramatically increase their financial reserves for loan defaults. Many industrial stocks had to close their manufacturing facilities, suffering huge losses. Even some consumer stocks failed to deliver on their promise of less volatile performance, especially those that sold less essential discretionary goods and were unable to quickly adapt their operations to a digital e-commerce model.
The net result was that low volatility stocks and the ETFs that owned them fell with the same intensity as the general market during the recession. However, they have not recovered like the other stocks. As a result, some are still from where they started in 2020, more than a year ago, and many others are still far behind the market.
Nothing works perfectly
It is always tempting to try to get the benefits of investing in the stock market without the risks involved. However, relying on defensive actions to protect you from the next stock market crash is, at best, reckless. No matter how well a stock may have done in the past, there is no guarantee that it will not be as vulnerable to the next bear market as any other stock.