Volatility is one of the most widely used, yet misunderstood, words in the investment world. It means so many things to so many people that volatility is at risk of becoming another Wall Street word that does not mean much of anything at all. Should that happen, many people will find themselves exposed to unnecessary difficulties at a time when so many are already concerned that the margins of safety of their investing lives are under threat from many different forces.
According to a recent Annual Aegon Retirement Readiness Survey, 16,000 workers and retirees across 15 countries said financial market volatility was one of their top three worries, following concerns that governments would reduce retirement benefits, and people would outlive their money. The concern about volatility seemingly comes from nowhere.
Since the Global Financial Crisis of 2008, world markets have essentially rallied higher, and volatility has ebbed ever lower as central banks used easy-money policies to save the global economy. These policies basically vacuumed risk out of the stock market. In 2017, the Standard & Poor’s 500 Index experienced the least volatility since 1965. The current investment year has certainly had some erratic moments – Feb. 5, for example – but the primary proxy of volatility, the CBOE Volatility Index, or VIX, remains around 12, far below the long-term average of 19.
While it seems paradoxical that people all over the world are worried about volatility when it barely exists in financial markets, the survey’s findings are likely a leading indicator. We all know the world’s major governments are struggling with massive debts thanks to the financial crisis. At the same time, many of the world’s largest economies have aging populations and people are relying on their portfolios like never before. Most people have not saved enough for retirement.
Those issues will likely exacerbate the already increasing difficulties many investors have remaining calm under pressure when markets suddenly, and sharply, decline. Some hedge funds are betting on this; they are tracking America’s aging patterns to get ahead of massive withdrawals from retirement accounts that could push stocks lower, or cause structural problems among the many low-fee investment funds that are so popular.
So what do you need to know about volatility?
Blackrock, the world’s largest investment manager, PIMCO, and Goldman Sachs, have told clients that volatility is an asset class like stocks and bonds. Yet, many people – and this includes huge swaths of people on Wall Street and Main Street – still think volatility refers to fluctuating security prices. After all, everyone likely remembers J.P. Morgan’s famous quip when he was asked what he thought of the stock market. He said it would fluctuate. A lot has changed since the great financier died in 1913.
While volatility definitely describes the ups and downs of investing, volatility is also a real, concrete part of markets that is traded and analyzed.
There is a volatility curve for the Standard & Poor’s 500 Index, and other indexes, and stocks. This is just like the yield curve for the bond market. A growing number of sophisticated investors – and this includes Warren Buffett – trade, track and analyze volatility because it influences all financial assets and the world’s markets. Even variable annuity prices are influenced by the volatility of the Standard & Poor’s 500 Index.
To us, volatility is part of a four-part framework for discussing investing with clients, and safeguarding portfolios. Many people, for example, think they own a diversified portfolio that protects them from the market’s inevitable ups and downs. In reality, most portfolios decline when the CBOE Volatility Index, or VIX, rises. This is why we analyze volatility and develop bespoke portfolio scores to help advisors track an otherwise invisible risk factor.
While entire books have been written about volatility – Natenberg’s Volatility is a favorite of ours – a few key facts will help most everyone better navigate the market.
First, imagine an ocean. Think of your portfolio as a boat on the water. When markets rise or fall, it generates waves. The waves are volatility and the waves essentially impact everything, even the shape of the sea.
There are two types of volatility – and this fact eludes many – realized (sometimes called historic) and implied.
Just as the moon controls tides, volatility is heavily influenced by realized volatility, which refers to what has happened in the past. Understanding historical volatility offers insights into trading patterns, and market personality. Low volatility securities, such as utilities, often do not move very much. High volatility securities, such as biotechnology stocks, are the opposite. Indexes, which are comprised of many different types of stocks, are usually somewhere in between. As stock prices rise, for example, realized volatility usually declines. If a stock sharply declines, say because of a bad earnings report, realized volatility can increase. Either way, realized volatility functions like a giant magnet on the financial market, and on implied volatility, which gauges what may happen in the future.
Implied volatility is concerned with the future, and it is the primary focus of many investors. If you can understand how volatility will behave in the future – and this is based on an understanding of historical volatility and various events that cause implied volatility to undulate – you have a keen insight into the behavior of stocks. Hence, many investors compare realized and implied volatility to contextualize the financial world.
Now, let’s consider VIX, which is the primary proxy for equity volatility. The fear gauge is designed to provide investors an idea of what might happen to the S&P 500 Index over the next 30 days. So, if VIX is around 12, it means the stock market is expected to move .75% each day for the next 30 days. Investors then decide if they think that level is appropriate, or not.
Historically, VIX’s long-term average is about 19, which implies that VIX’s current level – about 12 – will inevitably increase. Why? Because volatility is a mean reverting asset that behaves like a rubber band. Stretch it out, and it snaps back.
Bottom line: we live in an era of volatility that is increasingly influencing the nature of markets, and the pathway of portfolios. If you don’t know your volatility score, you’re missing a critical piece of the investment puzzle.