"For each, a road; For every man, a religion; Find everybody and rule; Everything and rumble; Forget everything and remember; For everything, a reason."
Ian Brown, F.E.A.R
But as we hope to demonstrate in this article, volatility is not the enemy of investing. Indeed, because it is so intrinsic to financial markets, it can present a useful opportunity to astute investors. Furthermore, high levels of volatility do not necessarily translate into worsening returns.
Before going into why we should not necessarily fear volatility, let’s look at a few concepts about volatility and markets.
Volatility, simply put, describes the amount by which the price of a security varies over a given period of time. Large rises and falls on a day-to-day basis will characterise a volatile share, index, currency or bond. However, because as humans we tend to feel the pain of a loss more acutely than the joy of a gain, we tend to notice volatility more when shares fall than when they rise. So we associate volatility with the risk of loss, rather than the potential for gain.
Higher volatility can be a useful tool for the smart investor or trader. For a longer-term investor, volatility matters less, because solid fundamentals will always outweigh short-term effects over the longer period. To use the oft-quoted saying by Benjamin Graham: in the short-term the market is a voting machine, in the long term it’s a weighing machine.
Long-term investors will welcome bouts of volatility because they see sharp falls as an opportunity to buy a share at a cheaper price. A common lament among leading investors goes along these lines: “I really like this company, but at this price / valuation I can’t justify buying it.” Volatility gives such investors the chance to buy previously expensive shares.
For traders, volatility provides the opportunity to make money from betting on short-term moves, often through derivatives like futures or options, or through contracts for difference. Of course it also gives the opportunity to lose large sums of money too, so you really need to know what you’re doing. Professional traders will adopt various strategies for playing volatility in different ways. It’s not a game for the fainthearted.
For the purposes of this article, we’ll be focusing on the importance of understanding volatility for investors who take a longer view. But first, a few definitions.
Ways of measuring volatility
Various measures that use volatility as their core have been adopted by the investment industry to quantify how much risk was taken to realise a gain. These include the Sharpe ratio and the Sortino ratio. The greater the volatility, the greater the risk taken.
Implied volatility is thus a good measure of how skittish or relaxed the market is about future price movements. And numerous exchanges now publish indices of such volatility, that one can further trade in.
The most famous of these is the Chicago Board Options Exchange (CBOE) Volatility Index, better known as the VIX. The VIX, introduced in 1986, measures the volatility implied by the price of options on the S&P 500, and is often called the “fear index” because it is a good barometer of investor sentiment. The higher the VIX, the more fearful the market is of losing money; the lower it is, the more relaxed markets are.
Similar indices exist for other stock markets around the world, but because global stock markets tend to move together and the S&P 500 is the largest, the VIX is used as the standard for equity markets generally. Volatility indices also exist for bond and currency markets.
VIX over the years
None of this should be a surprise when we consider some of the market moves over the last few months. US dollar strength, rising US yields and uncertainty over the outlook for US short-term rates (three rate hikes or four this year is the big question), together with the breakdown in the synchronised growth story that defined the world economy over the second half of last year, have all contributed.
So too have the ongoing geopolitical events around North Korea, trade tensions between the US and China and political upheaval in Europe. But what does this mean for market returns from here on?
Forget everything and remember
As the chart below shows, periods of heightened volatility have often been associated with rising market returns. Those of us with long memories will remember the 1990s as a period of major market upheavals, including the Asian currency crisis of 1997 and the Russian debt crisis of 1998 (both clearly identifiable in the VIX chart), yet the S&P 500 set a number of record highs over that period, despite these bumps in the road.
Volatility over the years
When investors should perhaps be rightly fearful is when a VIX spike leads into a recession. However there are few indications that we are into that scenario here. Central banks are still largely cautious about moving too quickly from their previously very loose monetary policy stance, into a more normal stance.
So far, the European Central Bank and Bank of Japan are still engaging in asset repurchases, though the pace of the former has slowed and there is talk that it may scale it back further this year. The US Fed is the only major central bank in a tightening cycle, but these are still at very low interest rates.
History shows that the warning sign is the yield curve, rather than the VIX. The last seven US recessions have followed a yield curve inversion, usually when the Fed is deep into a hiking phase. This is the point when short-term interest rates are higher than long-term rates. The chart below (the difference between US 10-year and two-year Treasuries), shows the last two of these inversion points, when the gap fell below 0, in 2001 and 2007. Both were followed by recessions. With 10-year rates still about 0.5 percentage points above two-years, we should still have some way to go.
US yields 1994 to 2018
Source: Iress, I-Net
Conclusion – the only thing we have to fear is fear itself
About the author
Patrick writes and edits content for Investec Wealth & Investment, and Corporate and Institutional Banking, including editing the Daily View, Monthly View and One Magazine - an online publication for Investec's Wealth clients. Patrick was a financial journalist for many years for publications such as Financial Mail, Finweek and Business Report. He holds a BA and a PDM (Bus.Admin.) both from Wits University.
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