One of the first things that beginning investors learn is that in order to earn the best returns, you need to take more risk in your investments. Yet as so often happens with theoretical axioms of financial theory, real life experience isn't nearly as simple, and in this case, you'd be better off turning traditional rules on their head and making the more counterintuitive move with your money.
As it turns out, stocks that are less volatile have actually produced better returns than their riskier counterparts over long periods of time. Although the low-volatility strategy didn't produce stronger absolute returns in 2012, a return to conditions that favor the strategy in 2013 looks increasingly likely and could reward those who take steps to secure their portfolios now.
Why low volatility wins
A study from late 2011 took a closer look at the question of what returns less volatile stocks produced compared to the overall market. With the study having taken place after the financial crisis, the short-term results confirmed what just about everyone already thought: that during bear markets, the least volatile stocks in the S&P 500 produced much smaller losses than the broader index.
That result wasn't surprising because it was already a widely followed strategy. During scary moments for the markets, investors often gravitate to what generally get called "defensive stocks" in industries like consumer goods that have stable demand regardless of economic conditions.
What was surprising, though, was that when researchers looked at longer time periods measuring over decades, they found that low-volatility stocks still outperformed the market. That result flew in the face of the idea that defensive stocks inevitably underperform by so much during bull markets that it more than makes up for the performance advantage over more aggressive companies during bear markets.
Subsequently, analysts have tried to explain that counterintuitive result. One possibility is that Wall Street investment firms tend to prefer investing in more volatile stocks because they're more likely to produce the short-term outperformance that professional money managers need in order to demonstrate their abilities. Because mutual fund investors usually chase performance, managers have little incentive to go after long-term results until they've built up a long-enough track record to prove themselves.
What happened in 2012
Of course, short-term results of any strategy won't always confirm its long-term impact. With the S&P 500 posting a strong 13% rise in 2012, many low-volatility stocks trailed the market's larger gains. In particular, utility stocks had a tough 2012 after posting spectacular results in 2011, as Southern (NYSE:SO) was among the few low-volatility stocks to post an actual loss over the past year. Several low-volatility utilities suffered the effects of Hurricane Sandy, as the New York City-area Consolidated Edison (NYSE:ED) and regional powerhouse FirstEnergy (NYSE:FE) had to deal with huge power outages and service disruptions and therefore had their shares put under pressure following the storm.
Yet some stocks bucked the trend and outperformed the market again. In the consumer area, Hershey (NYSE:HSY) and Colgate-Palmolive (NYSE:CL) both managed to outpace the S&P on the strength of their respective brands, overcoming pressures from high input costs to produce returns of between 25% and 30% over the past year. Those gains won't continue forever, but as long as other low-volatility stocks rise to take their place, the overall strategy should remain sound.
Why 2013 should be better
Moreover, as the aging bull market turns four years old, many investors are starting to wonder how much further the stock market can advance. So far, the market has resisted many potentially calamitous episodes to move higher, but with multiple potential problems around the world, a return to more conservative returns will be favorable for low-volatility stocks.
Taking risk is part of investing, but you shouldn't take unnecessary risk. Buying volatile stocks can produce huge returns, but you shouldn't buy them simply because they're volatile. Over the long haul, picking stocks with fewer bumps in the road may be boring, but you'll like the returns in the end.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Southern. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.