Earlier this year, I wrote about how a low-volatility approach to ETF investing worked and how utilities ETFs were a great way to target low-volatility stocks. In short, this approach has historically outperformed its index counterparts despite incurring higher fees and greater fund turnover. 

For those unfamiliar with low volatility investing, I suggest giving the first article a thorough read. In short, low-volatility investing involved screening stocks with a lower-than-average standard deviation and beta, which are measures of volatility and market sensitivity respectively. 

So, why should investors consider investing in low volatility ETFs in lieu of their lower-cost, passive index ETF counterparts? I think beyond the financial theories and mathematical explanations, there's a very simple behavioural benefit to low-volatility ETFs that investors shouldn't overlook. 

A brief introduction to behavioural economics

Most, if not all, investors are irrational. Like it or not, we are all susceptible to a common pattern of biases and heuristics that cause us to make less-than-optimal investment decisions. A notable one is loss aversion, which causes losses to feel much more painful compared to a commensurate gain. 

Loss aversion causes investors to act irrationally in various ways when faced with an unrealized loss. This is easily observable with the investors who double down on a poor stock pick, or with the investors who panic-sell an otherwise solid index fund at the first sign of a correction. 

That is, neither of these investors are rationally considering the fundamentals behind their investment decision or the market environment. They are acting more or less instinctively to minimize the pain from their losses, even if the actions aren't productive to their long-term returns. 

When it comes to investing, loss aversion is amplified when an investor holds high-volatility, high-beta investments. For example, technology ETFs saw strong higher net outflows this year compared to other ETFs in the face of heavy losses, despite still possessing favourable long-term return prospects. 

Why a shift in mindset and low volatility ETFs help

My personal gauge of risk is called the "keep me awake at night index." If I find myself losing sleep over how an investment is performing, it’s a gut check that it might be too much for my risk tolerance. Beyond the numbers and statistics, sometimes a simple behavioural check like this can help. 

Most investors do not think about risk in this manner. Your average financial advisor or investor considers the degree to which an investment has historically fluctuated around its mean (standard deviation), and the greatest peak-to-trough loss it has endured (max drawdown). 

What they don't consider is how this actually affects their portfolio's value. It's easy to think, "I'm OK with my portfolio fluctuating 15% over a year and losing up to 40%" in isolation. The percentages mean nothing to the average investor who has no reference point. 

A better way to reframe this risk discussion is by asking "am I OK with my portfolio of $100,000 moving $15,000 up or down in a given year and losing up to $40,000?". Putting a dollar figure on volatility and potential losses can help attenuate investors to their true risk tolerance. 

That's where low-volatility ETFs come into play. A risk-savvy investor can begin to appreciate their ability to deliver a lower-than-average volatility and max drawdown compared to regular index ETFs. They can offer a very real benefit in reducing the pain of losses felt by investors.

For those interested in low-volatility investing, BMO has a lineup of actively managed funds targeting Canadian, U.S., and international low volatility stocks. 

• BMO Low Volatility Canadian Equity ETF (ZLB): 0.39% expense ratio. 
• BMO Low Volatility U.S. Equity ETF (ZLU): 0.33% expense ratio. 
• BMO Low Volatility International Equity ETF (ZLI): 0.45% expense ratio.

Disclaimer: This article is limited to the dissemination of general information pertaining to investment strategies and financial planning and does not constitute an offer to issue or sell, or a solicitation of an offer to subscribe, buy, or acquire an interest in, any securities, financial instruments or other services, nor does it constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment.