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As Dow Drops, a New Case for Low-Volatility Stocks

New worries over Greece’s debt troubles sent stocks tumbling toward their worst day of the year — and reignited fears of more market tremors ahead. Should investors duck for cover?

Plenty of studies have argued that the best defense against wild market swings is to own lower-volatility stocks and funds. Investors may miss out on some upside, so the thinking goes, but they’ll also sidestep some of the market’s steep drops (such as the Dow’s 200-point plunge today). But some new research suggests that these lower-risk options may actually be the best offense, too. According an analysis by fund tracker Morningstar, less-volatile funds returned an annualized return of more than 5% over the past decade, beating higher-volatility funds by almost 1 percentage point a year.

Experts say the latest findings contradict what most investors accept as a basic investing principle – that more volatile shares generate bigger long-term returns. It also backs up earlier research, including a study published last year by researchers from Harvard, NYU, and Acadian Asset Management that found the lowest-volatility shares in the market significantly outperformed the highest-volatility stocks from 1968 through 2008.

To be sure, low-volatility strategies can lag in some shorter periods, notes Ethan Anderson, a senior portfolio manager at Rehmann Financial. For example, “low-beta” shares such as dividend stocks and utilities have been trailing the market during this year’s rally – after strongly outperforming in last year’s choppy markets.

But over longer time periods, less-volatile shares tend to catch up and outperform, according to the Morningstar research. And even if a low-beta strategy underperforms during a rally, it’s typically still in the black, says Anderson — an attractive tradeoff for many long-term investors and retirees. Plus, a low-volatility strategy may make  it easier for some jittery investors to stick to the long-term plan when the market starts to swing, Anderson says.

If the argument for less-volatile stocks is so strong, why do so many investors still believe they have to take on more risk to get higher returns? The researchers from Harvard, NYU and Acadian Asset Management offered a few theories. For one, investors may feel about high-volatility stocks the way they feel about lotteries: The payoff is big enough to make the risk seem worth taking.

It’s also possible they focus too much on the stories of a few speculative investments that paid off big and conclude that taking risks is the best way to make money, instead of carefully considering the evidence that shows slow-and-steady stocks offer the highest probability of good returns. And lastly, overconfidence likely plays a role, too, as studies have shown that people tend to overestimate their ability to give the correct answer to complicated problems — like where the stock market is headed next.


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