Volatility has recently spiked in the US stock market, after trending downwards since the autumn of 2002.
Why does this volatility matter, and why should equity investors be worried? Because increased volatility makes it more likely that you will experience negative returns in your equity portfolio. In his recent book "Unexpected Returns", Ed Easterling has done a detailed study of the relationship between volatility and stock market returns.
He divides the last 480 months (40 years) into quartiles based on volatility. Those 25% of the months with the lowest volatility fall into the first quartile, etc. In the first quartile there is only a 31% chance of experiencing a month with negative returns. In the second quartile the probability rises to 37% and in the third quartile to 43%. In the quartile with the highest volatility, the chance of a down month is 57%.
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Furthermore, volatility not only increases the probability of negative returns, but the magnitude of those losses increases as well. In other words, when volatility rises, you will lose more often and the losses will get bigger. As many investors will know from experience, it is incredibly hard to recover from large losses.
Say you lose 25% in a really bad year for equities (this happened as recently as 2002). In order to recover those losses, you need for your portfolio to be up not 25% but 33% (the law of maths). Say you have two really bad years and find yourself down 50%. Now, in order to get back to zero, you need for your portfolio to appreciate by 100%. We do not need to remind you how difficult that is.
Since 1990, the volatility index has shot above 30% at least six times (not counting a few twin peaks). The recent increase cannot yet be characterised as a major spike, but the conditions are in place for one. In terms of equity market performance, the odds would turn against you if it were to happen.If the volatility index continues to rise, we therefore suggest you resist any temptation to add to your equity positions on weakness; it is not worth the risk. If, however, the current spike turns out to be temporary, the odds are turning in your favour again, so keep a close eye on it.
By Absolute Return Partners, a London-based private partnership which provides investment advisory services globally to institutional and private investors.Visit www.arpllp.com for more.
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