Although financial markets have been relatively calm thus far in 2017, there is a widespread perception that volatility has generally increased over time. 2016 might seem a prime example in this regard, with ever-changing fundamental developments (China, Brexit, Trump) sending markets on the proverbial rollercoaster ride.
Volatility can cause investors to act emotionally and to throw their investment plan out the window, so it’s important to ask: have things actually changed? Are today’s markets really more unnerving than the markets of old? Or is it the case that ordinary investors tend to underestimate just how volatile stock markets have always been, resulting in them mistaking today’s normal market oscillations for something more rare and sinister?
The perception that 2016 was a volatile year is understandable. Stocks endured their worst-ever beginning to a year, the panic encapsulated by an RBS analyst note that implored investors to “sell everything”.
Further heavy selling was witnessed in the immediate aftermath of the Brexit and Trump polling surprises.
The S&P 500 nevertheless recovered, soaring 24 per cent between early February and mid-December. Crazy stuff, yes?
Not so, noted hedge fund manager Cliff Asness last month. Looking at data going back to 1929, Asness found that in terms of daily volatility, 2016 was at the 47th percentile – that is, it was more volatile than just 47 per cent of previous years. Are the stats being distorted by the crazed years of the Great Depression and the second World War? No – 2016 ranks at the 54th percentile if one's starting point is 1946 and at the 42nd percentile since 1990.
Perhaps daily volatility is not a reliable measure of volatility? What about other measurements, such as the biggest one-month change in equity prices? The biggest movement took place between mid-February and mid-March, when stocks soared 10.4 per cent. Nothing strange about that, said Asness – it comes in at the 44th percentile since 1929, the 51st percentile in the post-war period, and the 48th percentile since 1948.
Still, stocks roared higher after February, rising 24 per cent. That’s a big move. Again, this wide range is actually very normal. It comes in at the 42nd percentile since 1929, the 49th percentile since the second World War, and the 50th percentile since 1990.
Don’t congratulate yourself “for surviving such a crazy 2016 market”, cautioned Asness. 2016 was actually an “amazingly normal” year.
Daily volatility
That’s not to say markets haven’t changed over time. Research shows the exponential growth in exchange-traded funds (ETFs) has changed trading patterns, with stocks held in such funds experiencing substantially higher intraday and daily volatility than stocks that are rarely held in ETFs.
Similarly, daily volatility has increased substantially in recent decades. According to the authors of The Increasing Volatility of the Stock Market?, a paper published last summer in the Journal of Wealth Management that aimed to address the "widely held perception among market participants and the general public that stock market volatility has increased over time", daily volatility has more than doubled.
Less than 0.5 per cent in 1940, daily volatility was averaging more than 1 per cent in 2014, with the trend beginning around 1970.
However, an increase in daily volatility might be relevant for hyperactive traders but it shouldn’t trouble ordinary investors.
As for monthly volatility, the authors found that modern markets are little different to the markets of old.
Why volatility is inevitable
Stocks have always been and always will be volatile. This point is often hammered home by Morgan Housel, a partner at the New York-based Collaborative Fund and a former columnist at the Motley Fool and the Wall Street Journal.
Including dividends, stocks have historically averaged annualised gains of around 9 per cent but many investors steer clear because they don’t fancy the wild ride. If there was no wild ride, if stocks simply climbed 9 per cent every year without any big swings, then everyone would obviously pile into equities.
Of course, if everyone did that, then prices would rise and stocks would become extremely expensive, setting the scene for the inevitable correction and the return of volatility. Accordingly, volatility is a constant in financial markets, not an aberration; a feature, not a bug.
Media coverage
The media does not help in this regard. Much coverage is sensationalist, while even sober, well-meaning commentators rarely offer a detached analysis that examines current market movements in a historical context. The absence of evidence-based analysis was what inspired Cliff Asness to crunch the historical numbers for 2016 in the first place in an effort to correct commentaries that “implicitly and sometimes explicitly, makes it [2016] sound as if it was a crazy year”.
Additionally, the media often focuses on absolute rather than percentage changes in index prices. Investors might be alarmed to hear that the Dow Jones Industrial Average has “plummeted” 180 points, but that’s a decline of less than 1 per cent, which is hardly cause for grave concern.
The potential impact of this reporting should not be underestimated. Studies have shown that people suffer from denominator blindness – that is, "the failure to put big, scary numbers into context", to use money manager Barry Ritholtz's colloquial definition.
An example: in one Japanese study, participants were asked to assess the riskiness of 11 well-known causes of death. The study found that participants believed cancer to be riskier when it was described as “kills 1,286 out of 10,000 people” than as “kills 24.14 out of 100 people”. The larger number in the first case blinded people to the reality that it described a mortality rate of less than 13 per cent, compared to more than 24 per cent in the second example.
Studies also show that people seriously misjudge accident risks as a result of this denominator blindness and that it affects the size of jury awards for punitive damages. Large numbers sway people; many an investor is likely to have sold in panic as a result of a scary-sounding but ultimately unimportant decline in index levels.
Misunderstanding the nature of volatility is dangerous. Volatility, as author and GMO strategist James Montier likes to point out, is different to risk. Volatility is normal and creates opportunity so it should be regarded as the investor's friend. Instead, it's invariably greeted as a scary monster that has, for some sinister reason or another, descended on markets, causing irrevocable damage to portfolios.
That’s worth bearing in mind when 2017 likely brings its own volatility.
