Monthly Archives: December 2011

What is “Volatility” Anyway?

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!

Turn Off the Chatter!

There is a certain amount of intuitive appeal in the daily chattering of stock market commentary.  We have all been taught from the time we were wee little investors being dandled on our pappy’s knee that there is always a reason for the market’s daily movement.  There are several television channels and countless Internet websites dedicated to explaining the daily “reason” which all seem to have short memories, a limited sense of accountability and a brash confidence that would humble your average high school starting quarterback.

This concept is brilliantly highlighted by the simple daily market commentary headlines on Yahoo Finance.  We often joke around the office that the job of writing these headlines must go to the most junior person on the team, because it is really a thankless job that is nearly impossible to do well.  If the stock market falls 2% at the open, this young go-getter probably calls around to find out why.  The “reason” soon appears front page and center “Stocks Fall on Worries about Italian Debt Plan” (or whatever).  Thirty minutes later the market is up 1% and, lacking a good reason for this turnaround, the hapless intern updates the page with something like, “Stocks Rally Despite Worries about Italian Debt Plan.”  This may seem like an extreme example, but I have seen many headlines like this.

This desperate search for the “reason” would be fine comedy if it weren’t for some poor widow in Minot adjusting her asset allocation based on this kind of chatter.  I realize that I am some times hard on journalists, but I think the real problem for me here is that daily stock movements and journalism are not a good combination.  When everyone was day trading back in the go-go 1990s, it might have made some sense to listen to the market pundits 24/7.  Now, I’m not so sure.

One thing I learned in business school is that companies exist to make profits (profound, eh?).  I suspect that this applies to the media outlets who report exclusively on the markets as well.  As I understand it, these companies are paid by advertisers who will pay based on the size of the audience these outlets can attract.  So, while these outlets may feel obliged to comment on daily market news, they also have a fundamental need to increase viewership.  This may lead to the bad combination I hinted at above.  If one were really dedicated to helping individual investors make money and reach their financial goals, I think they would feature professional money managers who could offer solid, actionable, long-term advice to their listeners.  Instead, we get academics, traders, authors, government officials, economists and a host of other “gurus” who may not be skilled investors and who may not really have our best interests at the top of their priority chain.

Again, I am not a trained journalist, so I may be totally wrong on this, but which headline do you think is “better” for these outlets?  “Roubini: Italy at risk of exiting euro  zone” or “Buffet: Stocks Look Attractive for Patient Investors.”  The problem with the Buffett quote is that he says things like this all the time.  It’s not really newsworthy, but it’s loads more helpful to the individual investor than the other one.  On the other hand, the Roubini quote may lead to a spike in viewership.  Which is better? Hmmm.

The data show (see the work of Dalbar) that the individual investor, in aggregate, is 1) bad at market timing and 2) highly influenced by the sentiment of the moment.  Even a very smart investor with a workable investment philosophy and approach can fall victim to the whipsaw action of sentiment.  Lauren Templeton, a professional money manager (and grand niece of the Sir John Templeton), at a recent conference suggested that there are three ways to “beat the market.”  Better information, better process or better behavior.  These days it is impossible for the individual investor to have better information or a better process vs. the big professional investors.  But, better behavior can still be applied to beat the market.  The problem is most investors behave badly when it comes to the market.  They feel like selling when they should buy and vice versa.

One simple way to improve one’s investing behavior is to not listen to the daily chattering.  If the market is down, maybe it’s because of some Euro problem, or maybe it’s just a lot of people freaking out about the fears they have in their hearts and heads.  The market being down (or up for that matter) may affect how you feel, but it should not change the way you invest, unless of course, you instinctively want to buy when it goes down and sell as it rises.  Ultimately, the stock market cares about three things – earnings, interest rates and sentiment.  Earnings are fine right now, up 12% in the latest quarter (which, by the way, marks the ninth quarter in a row of solid earnings growth) and 2012 should be another good year.  Interest rates remain low and the Fed has promised no tightening before 2013.  Sentiment, which is a contra-indicator, is quite negative now. Thus, from this simple formula, one could conclude that the stock market might be due for a nice rally.  Time will tell.

What I do know for sure is that people who try to trade around their portfolio based on the daily chatter rarely win.