What Is This Thing Called Volatility, Really?Sheaff Briefs Editor
“What is this thing called love, this funny thing called love?” is Cole Porter’s well-sung query, asking the Lord in Heaven above: “Why should it make a fool of me?” Recent market volatility has had many investors asking a similar question about the investment market. “Stock market volatility is a great way to test your nerves as an investor,” writes Leslie Albrecht in MarketWatch.com.
The Volatility 101 lesson here for investors, as Albrecht correctly points out, is this: “There’s a big difference between risk appetite and risk capacity.” For any individual, it’s the difference between how much you’re willing to risk and how much risk you can actually handle financially, she explains.
Sheaff Brock Managing Director Dave Gilreath is in total agreement about the differentiation between appetite and capacity. Gilreath, however, has an interesting observation about the term “volatility.” Ever since Harry Markowitz published his 1952 paper on Modern Portfolio Theory, he believes, investors have thought of the two words “volatility” and “risk” as being synonymous. They are not, he stresses: in fact, they are two totally different things.
(Ready for Volatility 201?)
Since the early 90s, analysts have measured market volatility by the VIX. This a thirty-day, forward-looking measure of the volatility in the S&P 500 stock index as determined by option premiums. In other words, the VIX is a predictor of movement (up OR down) in the stock market in the next thirty days. (Psst … When the VIX goes up, that means people are scared, Gilreath explains.)
- In the 25 or so years since the VIX was established, the average VIX reading has been 20.
- Over the last three years, the VIX has been at a 10–12 level (Translation: Investors have been “lulled”).
- Today’s VIX of 25 is actually showing us getting back to “normal.” We are not in an abnormally volatile market, Gilreath points out.
“The VIX Index is a financial benchmark designed to be an up-to-the-minute market estimate of expected volatility of the S&P 500 Index,” as the Chicago Board Options Exchange (CBOE) defines the term. “More specifically, the VIX Index is intended to provide an instantaneous measure of how much the market thinks the S&P 500 Index will fluctuate in the 30 days from the time of each tick of the VIX Index”.
What is this funny thing called volatility? Like love, it may be, by its very nature, frustrating, but, in the final analysis—it’s normal!