If one thing is certain in this investing game, it is that markets will rise and fall (no matter what Gordon told us). Combine the herd mentality of human beings with a free market economy and you’re guaranteed to end up with a roller coaster ride of prices, yields, growth, boom and bust i.e. volatility.
What is Volatility?
Volatility is simply a measure of how much prices move by, up or down.
Of course when markets fall quickly, volatility will increase every time. As a result volatility is usually associated with times of falling prices.
If the stock market falls 50% from a price of 100 (-50 points), it only needs to rise by 25 points in order to post a 50% increase. If the price rose by the 100 points it lost it would represent a +100% increase.
This effect means that by as a financial crisis unfolds in the markets and prices fall, volatility will almost inevitably increase. We rarely see a very slow decline to crisis, we usually see a big cliff fall followed by chaos.
As a general rule the more volatile an asset the riskier it is. For example, traditionally bonds have been less volatile than equities, predominantly due to their coupon being predetermined.
How to Calculate Volatility
So now we know what volatility is how do we calculate it? Calculating historical volatility of a security is a relatively simple process. Lets step through it….
1. Get some historical data. I usually use Google Finance. Once you have found the security you want to analyses simply click the ‘Historical prices’link to reach the page where you can define your date range and download the prices to excel.
2. Calculate the daily returns. To do this simply work out the % move in prices from one day to the next. See column C in the spreadsheet below.
3. Work out the standard deviation. Next up is to work out the standard deviation of the returns then multiply this by the square root of the number of trading days in the year (254 in my example data). See cell D2 in the example xls.
Using the FTSE 100 in my example the annualized historical volatility is 12.05%. This in effect means that based on the historical volatility we can expect the FTSe to trade within 12.05% of it’s current price, or in other words 5,672-7,226.
Download the example xls here.
Alternatively if you’re feeling lazy you can use a volatility index such as the VIX…..
The VIX is an index that measures the implied volatility of S&P 500 index options. The VIX (quoted as an annualised %) is quoted by the Chicago Board Options Exchange and is therefore a trade able asset.
At the time of writing the Vix is quoted as 21.44% and the S&P is at 1741 point. This means that over the next 30 days, the market expects it to trade within a range +/- 6.19% (21.44/SQRT12) or between 1,633 and 1,849 points.
Of course you need to remember that this is only what the options market is implying. There is nothing stopping the price from moving outside of this range during the next month.
Looking at the chart above you can clearly see that as markets fall, volatility spikes as we’ve described above.
Should I care About Volatility?
Well, much will depend on the type of investor you are (passive or active) and more specifically on what type of investing strategy you’re running. Don’t forget that you can be running very different strategies with the same asset.
For example….I’ve been a landlord for over 10 years now, including the property crash of 2008. With many people talking of another housing bubble forming should I fear the impending house price volatility everyone is talking up?
Well my property investments are pretty long term and passive. If prices fell 40% tomorrow I wouldn’t be overly concerned. I’m confident my rents will continue to increase with inflation and so long as interest rates stay in single digits my funding will be manageable. Because I never intend to sell I’m ambivalent to house price volatility.
Of course if I was a London based property developer buying rundown houses and flipping them every 6 months then any increase in volatility may well threaten the profitability and/or the existence of my business. As a result how volatility affects you depends very much on your strategy, not just the assets you own.
High volatility can be a difficult thing for investors to deal with psychologically. If you’re not confident in your strategy fast price swings can tempt you into making rash decisions.
Finally, certain financial products will become cheaper or more expensive as volatility changes (irrespective of price levels). For example the cost of Guaranteed Equity Bonds will generally increase in times of high volatility as the issuer will be facing greater uncertainty of returns they can generate and so will offset this risk by charging you more for such a product. In general any structured product that offers guaranteed or minimum returns will become more expensive in times of high vol.
Often the best time to buy assets are during periods of very high volatility. If you’d bet the house on UK equities in March 2009 you’d be a very happy camper today.
Strategies to Manage Volatility
Working in a bank I’ve been able to study at close quarters how traders react to different market conditions. Without a doubt their natural environment is a volatile one….and for good reason. Volatility presents opportunities, not just threats.
This whole investing game is about trying to spot inefficiencies in the market. Trying to find value in securities others haven’t seen, trying to benefit from when the market has mis-priced a situation.
High volatility is an indication that the market has/or is getting it wrong. For prices to rise you need a market that is in consensus about value of a security. If we all think it is good value we’ll bid up the price (also causing the yield to fall for you income investors) until we all think it is over valued, at which point the price will fall. However when the market is filled with uncertainty the human instinct is sell. If we all do this then the price falls, even if the underlying security is now clearly undervalued. This effect is a financial type of group think.
So, how should we deal with volatility?
Increase Your Holding Period
As is shown in one of Monevator’s nice graphics, one way to negate the effects of volatility is to simply increase the holding period of your investments. By ignoring short term price fluctuations you should be able to wait until prices return to their mean.
Another simple strategy to help you avoid volatility is to increase the diversification of your portfolio. For example ‘normally’ when equities fall, the value of bonds will increase as money flees to the perceived safety of government bonds1. In other words by investing in different assets with low (or negative) correlations you can minimise your exposure to volatility.
Buy a Low Vol Products
iShares have started to introduce a suite of so called ‘minimum volatility’ ETFs. Essentially they start of with a regular index (e.g. S&P 500) but they only include a subset of stocks that have historically low volatilities and low correlations to each other. By throwing out the high vol stocks you are theoretically left with a less volatile index.
If you’re approaching retirement and want to maintain a reasonable level of exposure to equities but fear the great end of QE fixed income crash (and the volatility this may bring) then these types of ETF might well be for you.
Re-balance Your Portfolio
You should always have a target split of assets in your portfolio. Lets say you maintain 60% bonds and 40% equities. If volatility increases and the value of your equities falls you’ll be forced to re-balance your portfolio by buying more equities to maintain your 60/40 split.
While the above re-balancing will expose you to transaction costs, the big benefit is that it forces you to buy assets (in this case equities) when they are cheapest – after a down turn.
Give Yourself an Option
If you fear the rumbles of volatility ahead then a relatively simple hedge you could put on is to buy a put option on the equity index of your choice. Doing so would give you the right to sell (say the FTSE 100) at a pre-determined price at a pre-determined date in the future.
Of course if this were the perfect hedge we’d all be at it. Unfortunately volatility is one of the key inputs that determines how to price an option contract. As a result, the contracts become much more expensive just when you need them. To really benefit you’ll need to predict the future a long way ahead.
Short the Market!
Of course if you’re (very) brave you could hedge some of your risk by shorting the market using a short strategy fund such as the ETFX FTSE 100 Super Short Strategy x2 ETF. Be warned this type of ETF isn’t for the inexperienced. This particular ETF aims to return twice the inverse performance of the FTSE 100. So by investing in it you’re not only shorting the market but you’re doing so with leverage. BE WARNED!
So as the the New Year has brought us some volatility back into the markets it’s worth considering your strategies for dealing with it.
1. Of course this changed some what during the European sovereign crisis of 2009.