If you think the main impediment to solid long-term investment returns is lousy stock picking, then think again. Yes, there are many factors that can hinder investment returns — missing out on fast-growing IPOs, having an advisor who steers you wrong, high fund expenses or taxes, an uncertain economy — but in my experience, the biggest threat to solid long-term returns is volatility.
 
Extreme fluctuations and instability in the market are so dangerous because they weaken investors’ resolve, causing many to panic and “sell low.” In such cases, they tend to pull out of stocks completely and refuse to get back in until they’re absolutely sure the market is recovering, which could take weeks, months or even years. By then, they’ve usually missed out on a huge portion of the recovery that typically occurs after periods of high volatility. This leaves these investors a lot worse off than they would have been had they simply left their investments alone.

I hate to see this happen, because it defeats the purpose of investing: to reach long-term financial goals. So the best way to minimize the negative effects of volatility short of eliminating stocks from your portfolio (a move virtually no financial advisor would recommend) is to hold a healthy portion of the “safest, most boring” dividend-paying equities available. (StreetAuthority’s Co-Founder, Paul Tracy, calls these types of securities “Forever Stocks.” These are stocks that, no matter what happens in the economy or the stock market — short of absolute Armageddon — you could feel reasonably safe about owning over the long-term.) These include stalwarts like Procter & Gamble Co. (NYSE: PG), Coca-Cola Co. (NYSE: KO) and Caterpillar Inc. (NYSE: CAT), among others.

Measuring volatility and protecting your portfolio
A key metric to determine the risk of a security is the beta coefficient. The beta compares a stock’s price movement to that of the overall market. A value of 1.0 means a stock moves in line with the market. So a stock with a beta of 0.6 — as is the case of Procter & Gamble, for instance — means it is 40% less volatile than the market. In fact, the company has returned 6.6% annually in the past 10 years, compared with a 4.3% rate of return for the S&P 500.

Another way to protect your portfolio against unexpected fluctuations in the market is to invest in a basket of stocks. There is a wide selection of mutual funds and exchange-traded funds (ETFs) from which to chose, but there’s one fund in particular that’s worth a closer look: PowerShares S&P 500 Low Volatility (Nasdaq: SPLV).

Here’s why I think this is one of the safest investing options for the long haul…

Although it has existed less than a year (the inception date was May 5, 2011), this ETF already holds $1.3 billion in assets and has quickly become one of the most popular low-volatility funds on the market. This is not only because it’s cheap to own (the expense ratio is 0.25%) — but because it’s simple and transparent. The fund, which has a beta of 0.7, simply tracks the S&P 500 Low Volatility Index of the prior year’s 100 least-volatile stocks from the S&P 500. The lower the amount of volatility a stock showed during that period, the greater the weighting it will generally receive in the Low Volatility Index. As a result, PowerShares S&P 500 Low Volatility is rebalanced quarterly to ensure it closely tracks the composition of the index.

Not surprisingly, the fund emphasizes defensive industries such as utilities, packaged foods and household products. Since stocks in these sectors tend to pay good dividends, PowerShares S&P 500 Low Volatility also has an attractive yield of 3.2%.

The following table lists the fund’s top 10 holdings as of Jan. 31, 2012…



Risks to Consider:  After a rocky 2011, it’s no surprise “safer” offerings such as PowerShares S&P 500 Low Volatility fund are gaining popularity. But although they can provide a nice downside cushion, these securities may also limit volatility to the upside, leading to underperformance during bull markets.

Action to Take –> Most of the stocks in the table above are exactly the kinds of “Forever Stocks” StreetAuthority Co-Founder Paul Tracy talks about in his Top-10 Stocks newsletter. And because it dampens both upward and downward price movements, PowerShares S&P 500 Low Volatility is, by nature, a great long-term investment. It may noticeably lag the market in the short and intermediate-term, but within a decade, two decades or more, it should perform about the same or better. If used as a core holding, it should also make the market’s ups and downs easier to stomach and, in turn, make it easier for investors to hang in for the long haul.