Before the age of cable TV and internet, if you were in New York City on a weekday, you could always tell when the stock market was way up or way down on a particular day. You simply had to look at how big a crowd stood outside of the discount brokerage (Schwab, Fidelity) offices, watching the stock ticker, or waiting on line (this was back when on-line only meant standing, not surfing) to use a market monitoring machine called a "Quotron." Today we track the markets' moves on 24-hour cable networks, the web and our mobile phones. The information is at our finger tips. But that does not change the nature of markets, only the way we find out about what happened.
After market volatility was relatively high during the financial crisis, more recently it has fallen sharply. Like the kids game "Where's Waldo," investors may have noticed a marked reduction in volatility, and are asking "Where's Voldo?" Will he return? That’s a tough call for any market-watcher. What is most critical for you, is to understand what risks and opportunities a highly-volatile stock market brings (assuming Voldo returns and moves back in). First, let's explain what "volatility" is.
In layman's terms, it describes the degree to which stock prices are bobbing up and down over a period of time. To quantify this, the "volatility index," nicknamed "VIX" was created in 1993, and measures volatility every minute of every day that the stock market is open.
Historically, readings have been as low as 9 during complacent period, but have spiked as high as the 40's-60's during emotional periods such as 9-11 and the Enron fiasco. The credit crisis sent the VIX to a new high of near 80 at the end of 2008! For most of the late 1990s, the 20-30 level was common. The past couple years, the VIX has spent nearly all of its time under 30, often in the low teens.
OK, so that's the quant-geek definition of volatility. In English, what does it mean? Low volatility can be interpreted as investors being complacent, not worried. High volatility implies an element of fear in investors' current attitudes. When volatile markets come around, it is not the actual VIX level that is most important. Understanding of the way the rules of engagement for risk management and return strategies change (and they can change a lot), is the key. The difference between fearing volatile markets and capitalizing on them is, in our opinion, a key element to the long-term success of any investment strategy.
We study volatility closely and have built Sungarden around the concept of managing it in our portfolios. We think that having a strategy to confront both high and low volatility markets is the key to finding success in the 21st century equity market.
Voldo's around here somewhere. Look out for him. And, ask us any questions that will help you better understand this most important concept.
© Sungarden Investment Research