Want to Skip the Next Stock Market Crash? Don't Fall for This Dangerous Investing Myth

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The stock market has exploded higher over the past 11 months, rebounding sharply from the coronavirus bear market and producing amazing returns. Some stocks have seen their share prices double, triple, or rise even further on optimism from their shareholders about the future course of their underlying businesses.

Yet whenever the market moves up quickly, some investors get nervous about whether a stock market crash is imminent. In order to protect themselves, some of those investors rely on certain types of stocks that are seen to be 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 a whole portfolio of them — you simply have to be aware that they can’t offer complete protection against a market downturn.

Image source: Getty Images.

The myth of low-volatility stocks

Investing in low-volatility stocks became a big trend in the aftermath of the financial crisis in 2008 and early 2009. Investors wanted to put money in the stock market, but they didn’t want to be subject to the huge swings that major benchmarks like the S&P 500 went through during bear markets. Instead, they hoped to find investments that would provide solid returns but with fewer bumps along the way.

Several ETFs became popular in the wake of the low-volatility investor movement. They included iShares Edge MSCI Minimum Volatility USA (NYSEMKT:USMV) and Invesco S&P 500 Low Volatility (NYSEMKT:SPLV), which both came to market in 2011.

The stated objective of these ETFs was to invest in stocks whose price movements had historically been less volatile than the overall market. As iShares put it, those stocks have “potentially less risk,” and historically, those stocks had declined less than the overall market during downturns.

Yet when the coronavirus bear market happened in early 2020, it turned all the old rules on their head. As a result, low-volatility stocks failed to deliver on the expectation that they’d suffer less dramatic hits than their higher-volatility peers:

SPLV data by YCharts.

What happened?

The problem with looking at history in coming up with an investing strategy is that history doesn’t always repeat. In the case of the bear market a year ago, conventional wisdom about which stocks would do well turned out to be completely wrong.

As it turned out, many highly volatile, high-growth tech stocks were the best performers in the stock market. The COVID-19 pandemic made these companies essential because of their capacity to enable businesses to make a rapid digital transformation in order to adapt to public health measures like business closures and lockdowns.

By contrast, many traditionally defensive industries didn’t fare nearly as well. Financial stocks, for instance, suffered as the threat of high unemployment forced banks to boost their financial reserves for loan defaults dramatically. Many industrial stocks had to shut down their manufacturing facilities, taking huge losses. Even some consumer stocks failed to deliver on their promise of lower-volatility performance, especially those that sold less essential discretionary goods and couldn’t 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 did during the downturn. However, they didn’t bounce back like the other stocks did. As a result, some are still down from where they started 2020 more than a year ago, and many others are still badly lagging the market.

Nothing works perfectly

It’s always tempting to try to get the benefits of stock market investing without the risks involved. However, counting on defensive stocks to protect you from the next stock market crash is foolhardy at best. No matter how well a stock might have done in the past, there’s no guarantee that it won’t be just as vulnerable to the next bear market as any other stock.