Maybe it’s my background as a language major in collage. Maybe it’s my general penchant for prose. But, there is something about language that truly fascinates me. The active math/science part of my brain also seeks for clarity of logic and precision in communication. So imagine my consternation whenever I begin to hear and read things about the markets that I know is unclear, imprecise and/or just plain wrong.
The latest target of bewilderment is the concept of “volatility.” Everyone knows [quick aside: whenever you hear anyone say “everyone knows” be on your guard – the words that follow could lead you to a profitable trade – by doing the opposite] that the markets this year have shown unusual volatility. I have probably heard/read comments along this line hundreds of times (I read a lot) this year. For most people, hearing something over and over leads them to accept it as true. To the contrarian, it has the opposite effect – the more I hear something the less I believe it. In my heart, I believe that the consensus (about most things) is generally wrong. I can produce reams of research that support this, but I find it nearly impossible to convince anyone of this fact.
So we all (except me, maybe) think that the market has been “extra” volatile this year. Is there a way to measure this? Volatility, at its heart, is a measure of the price variation of a financial instrument over time. Looking at the VIX (which measures the volatility of the S&P 500), we can see that the second half of the year appears more volatile than the first.
Yet, looking at a 2-year chart, we see that even the current volatility is much less than the peak levels of this and last year. Does anyone remember the worries and “volatility” of last May? It seems (according to this chart) that last year was as “bad” as this year, and yet no one talks about the increased volatility of 2010.
Looking at the five-year chart of the VIX, we can gain even more perspective on this issue. The volatility spikes experienced in late 2008 and early 2009 are roughly 3 times the level of the current volatility. So, one way to say it is that the S&P 500 is 70% less volatile than it was at that time. While this is true mathematically, this notion seems out of synch with the common knowledge of the day, that the market is somehow “more volatile.”
This is the point where unclear thinking and imprecise language can trip us up. When I hear “volatility,” I am thinking “variance from the mean.” I suspect most professional investors would agree. When others use this word, I sense they take it to mean “the market is down (or a recent variant ’broken’)” or “I am losing money.” So how much money have investors lost this year, this year marked by this supposed increased volatility? As of this writing, the S&P 500 is down about 2% for the year, which means the total return (including dividends) is around zero. Not a great year for stocks to be sure, but not horrible. Not as bad as one might expect given the “increased volatility.” Your results may vary.
The key concept here is that volatility affects mostly how we feel about the markets. Most of us would like the stock market to provide stable, linear returns of 10% or more each year. But, alas, that is not its nature. Its nature is to provide an average return of 10% over time with lots of volatility. The market almost never returns 10% in a calendar year. To expect this means you almost always will be either surprised or disappointed. Left to their own devices, the average individual investor tends to sell when things look bad (or “volatile,” if you will) and buy when things have “stabilized” (another imprecise word that usually means “the market has gone up”). I have tons of data to support this premise as well, but well, it’s hard to explain this to anyone who feels bad because the market is “volatile.”
Looking at the performance figures available, this has been a frustrating year for many professional investors. It’s been a very hard year to “beat the market.” Yet for those investors who thrive on volatility (traders, quants, computers, etc.), it’s been a very good year. As a long-term investor who does not trade actively, I fit into the former category. Yet, I am encouraged by the progress individual companies are making. Economic worries will come and go, but ultimately for stock pickers like me, the fortunes of individual companies will be more important for my returns than the economy, government policy, currency, or even “the market.” Here’s to a better year in 2012 (historically U.S. Presidential election years are good for the market) and more intelligent commentary (that is to say, commentary that is more intelligent – sorry for being imprecise…) from the “gurus” on television. Skål!