The stock market has exploded higher over the past eleven months, falling sharply from the coronavirus bear market and delivering incredible returns. Some stocks have seen their share prices double, triple or even rise further on their shareholders’ optimism about the future course of their underlying businesses.
However, when the market moves fast, some investors become nervous about whether a stock market crash is imminent. To protect themselves, some of the investors rely on certain types of stocks that are considered less volatile than the overall market. But before you go out and buy a bunch of defensive, low-volatility stocks – or a low-volatility ETF that gives you diversified exposure to an entire portfolio of them – you simply need to has to be aware that they cannot provide complete protection against a downturn in the market.
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The myth of low volatility stocks
Investment in low-volatility stocks has become a major trend in the wake of the financial crisis in 2008 and early 2009. Investors wanted to put money in the stock market, but they did not want to be subject to the big swing that important benchmarks such as the S&P 500 went through during bear markets. Instead, they hoped to find investments that would yield good returns, but with fewer bumps along the way.
Several ETFs have become popular due to the low volatility of investors. They included iShares Edge MSCI Minimum US Volatility (NYSEMKT: USMV) and Invesco S&P 500 low volatility (NYSEMKT: SPLV), both of which came on the market in 2011.
The stated objective of these ETFs was to invest in equities whose price movements were previously less volatile than the overall market. As iShares put it, the stocks have ‘potentially less risk’, and historically these stocks have fallen less than the overall market during the downturn.
When the coronavirus bear market took place in early 2020, it turned all the old rules on its head. As a result, stocks with low volatility could not expect to receive less dramatic hits than their peers with greater volatility:
SPLV data by YCharts.
What happened?
The problem with looking at history when coming up with an investment strategy is that history does not always repeat itself. In the case of the bear market a year ago, the conventional wisdom about which stocks would do well was completely wrong.
It appears that very strong volatile technology stocks with great growth have performed best in the stock market. The COVID-19 pandemic has made these businesses vital because of their ability to quickly enable businesses to enable digital transformation to adapt to social measures such as business closure and closure.
In contrast, many traditional defense industries did not fare nearly as well. Financial stocks, for example, have suffered from the threat of high unemployment that has forced banks to dramatically boost their financial reserves for defaults. Many industrial stocks had to close their manufacturing plants, and this suffered huge losses. Even some consumer stocks did not live up to their promise of lower volatility, especially those that sold less essential goods and could not 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 just as hard as the overall market during the downturn. However, they did not bounce back like the other stocks. As a result, some still lower than where they started with 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 reap the benefits of investing in stock markets without the risks involved. Relying on defensive stocks to protect you from the next stock market crash, however, is foolish at best. No matter how well a stock has done in the past, there is no guarantee that it will not be just as vulnerable to the next bear market as any other stock.