Long-term investors must live with volatility even though it spooks many of them, sometimes leading to irrational decisions. But learning to live with volatility is the price he or she must pay.

Why?

The same forces that drive up stock prices quickly are what drive them down quickly. And since it is seemingly impossible to predict when markets will head north or south quickly, the long-term investor must tolerate volatility. That’s because the stoic long-term investor is paid with fat returns in good times since he or she held on for a rocky ride in bad times. Live with it.

Such is conventional investing wisdom accepted by many market players and advisors. They argue or implicitly accept that the market force that drives up stocks—volatility—is the same force that drives them down. However, this is the kind of talk that spooks investors, leading some to exit markets. And that is one reason many can’t stick to a long-term financial plan. So today many are carrying a lot of cash, a decision that will likely drag down their returns. (See sidebar, “Cash Is Gold for Many Investors.”)

But the long-term investor, if properly educated, can live with and even prosper from volatility. This is the argument of the supporters of the low-volatility investing (“Low Vol”) strategy. They have constructed the S&P 500 Low Volatility Index. They contend that, while volatility is not avoidable, it can be managed and limited. This is what they call the low vol anomaly. Supporters of the strategy say it can, and has, worked.

“When the S&P 500’s volatility rises [as in 2002 or 2008], the S&P 500 Low Volatility has also tended to be more volatile, but its volatility is consistently lower than the S&P 500,” according to the S&P Dow Indices paper, “Is the Low Volatility Anomaly Universal?”

Supporters of this smart beta strategy argue that there is “a low volatility anomaly” that has been around for decades. This strategy provides an investor with most of the upside in bull markets, but avoids much of the damage in bear markets.

One buys certain stocks with reduced standard deviation and that can reduce losses in bear markets.

Alex Bryan, an analyst with Morningstar who recently analyzed Low Vol, called it a decent strategy for the risk-averse, and he is a qualified supporter. He notes that the Low Vol index is only some four years old and needs to be tested in a deep bear market. Still, he says the data tends to support the strategy. In a recent analysis, he agrees that Low Vol can miss some of the upside, but it still offers a good investment option for bear markets.

“Low vol is not a perfect measure of risk,” he wrote, “but it is worth heeding because it is directionally related to the probability of large losses.

“Stocks with low vol tend to hold up better during market downturns than those with high vol,” he added.

The S&P Dow Jones Indices paper concludes that the “evidence that low volatility persists, at least in the short to medium term, is strong.”

However, critics challenge the evidence. They argue that Low Vol backers have picked a good period to support their case, while not including others that compromise their case.

What is the evidence?

The S&P Dow Jones Indices paper reviewed 291 months in the period between 1991 and the first quarter of this year. The low volatility index outperformed the S&P Large Cap by 101 out of the 291 months, according to study. Those were the months the S&P 500 declined.

In the 50 months in which the S&P declined the most, the S&P Volatility Index outperformed it by an average of 2.89%. In the other 51 months, in which there were smaller drops, the S&P was outperformed by Low Vol by an average of 0.81%.

The bigger the losses in the market in any given month, Low Vol proponents argue, the more this strategy outperforms the S&P 500. However, they accept a sacrifice in upside returns. For example, in the S&P’s 95 best months—when it was charging up an average of 5.11% a month, the low volatility index lagged the standard benchmark by 1.73%.

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