Market volatility: to understand it better

Return and volatility: paired by fate

It is common knowledge that return on a financial asset varies according to its level of risk. But did you know that return and risk are two notions that are inevitably linked?
What’s more, the term "volatility" has recently become a popular topic of conversation.

• What is volatility exactly?
• What conclusions can be made based on volatility indicators?
• What is the relationship between these indicators and equity market fluctuations?

What is volatility?

The concept of volatility refers to a variable’s degree of unpredictable change over time. To most investors, risk represents the variability of an asset’s price. It is typically expressed as the standard deviation of the change in value of an asset over a given period typically one year. Volatility therefore reflects the risk taken by someone with exposure to said variable or asset. The more volatile the price of an asset, the riskier the asset will be.

Volatility is however much more than the standard deviation of an asset’s price over time. It is a critical input in valuing options and other derivative instruments. As such, measures of volatility - historical and prospective - impact the valuation and return of a wide range of financial instruments, from interest rates to futures. It also acts as a barometer of investor sentiment: while high levels of volatility indicate investor nervousness, low volatility signals a stronger appetite for risk.

Getting to know the VIX

The best known measure of volatility is the Chicago Board Options Exchange Volatility Index, or VIX. It is a measure of near-term implied volatility on S&P 500 Index Futures This index measures U.S. equity market output. Similar measures exist for the S&P 100 (VXO) This index is comprised of 100 leading US stocks from the S&P 500 Index and NASDAQ 100 (VXN)This index measures U.S. market performance and is comprised of the most dynamic small-cap equities. Each is a valuable indicator of market sentiment.

2008: Toward record volatility?

Introduced in 1993, the VIX Index has been steadily declining since its highs of 2002-2003, until recently. It hovered at historical lows throughout 2006, a period that was marked by a Goldilocks economy. Such extremes in low volatility were evidently accompanied by a strong appetite for risk. Observers make the case for structurally lower volatility in equity markets. Their main argument revolves around greater central bank transparency, more muted business inventory cycles in the developed world, and the impact of globalization on capital flows. When taken to the extreme, this line of reasoning points to lower long-term returns and risk from equities. There is some logic to the argument.

Cyclical trends in equity markets are driven by the economic outlook. To understand short-term market moves, one must analyze investor behaviour. The current increase in volatility may well reflect the fact that investors who had grown somewhat complacent toward risk had to reconsider its role in the equation. An economic slowdown and change in market leadership are common during the later stages of a bull market. The current shakeout in overconfidence (chart above) may have some time to run, and could in fact be setting the stage for future market advances.

A glance into the future

As the graph opposite indicates, historically, the VIX Index and the U.S. equity market (measured by the S&P 500) evolve inversely.
In layman’s terms, when the VIX hits new highs, the period is marked by increased uncertainty, during which investors seek to obtain higher compensation for risks incurred.
Once investors have regained their confidence, the VIX Index generally declines, and this environment tends to correlate with a market recovery.
The graph illustrates the phenomenon of the 1998 episodes, which followed the Asian crisis, and in 2002, following the burst of the technology bubble. Even if it is impossible to predict when the VIX will reach new highs in this period of increased uncertainty, it is no less evident that the index is already registering exceptionally high levels.

Holding your own

Market lows offer attractive buying opportunities for the investment savvy. To benefit from current conditions and maintain your peace of mind, adopt a long-term investment strategy. Don’t let market ups and downs shake your resolve. Better still, opt for regular investments.

With regularly scheduled investments, you buy more securities when prices are falling and fewer when they’re on the rise. In the long run, this strategy will lower the average cost of the securities you buy, which won’t happen with a once-a-year contribution. Predicting market moves and timing is no easy task, which is where this strategy comes in.

Based on an annualized return of 6%.

The opposite graph charts the results of regular investments according to the amount invested: the higher the monthly amount, the faster the investment grows in total value over time.

So, stay in the market! Invest regularly and think long-term!