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Leonard Gerber, a 65-year old financial planner, has seen plenty of volatile markets during his career. But this one feels different.
Across the country, investors are fleeing the stock market for the safety of cash. On Tuesday the Standard & Poor's 500-stock index lost as much as 2.2% before a late-day rally sent the index up 2.3% for the session. In the 46 trading days since the beginning of August, the S&P 500 has seen 29 swings of 1% or more.
Tuesday is a "perfect example" of why Mr. Gerber has bailed out. "The market is manic," he says. "There's no consistency ... and there's a worrisome amount of volatility."
The Wall Street Journal, October 5, 2011
Those who let emotions drive their investment decisions, as happened with Mr. Gerber and millions of others, missed out on the October market surge, the largest monthly stock market return in 20 years. These investors have unwittingly fallen prey to the “Volatility Trap,” failing to recognize – as our data show – that increased volatility is a precursor to higher returns.
Advisors are at the center of the volatility firestorm. Panicked clients call demanding relief and the simplest solution is to sell their equity position. Those advisors who believe stocks are the best long-term investment are forced to talk distraught clients down from rash decisions. The more ammunition advisors have for these heated discussions, the better.
In a previous article, Keeping Volatility in Perspective, we presented a long-term argument for staying the course in equities. If the advisor believes stocks have the best long-term expected return relative to other asset classes, then it is in the client’s interest to stay invested in stocks. So the volatility discussion revolves around the issue of short-term anxiety versus long-term benefit. In this article we present evidence that there is not only a long-term benefit but also a short-term benefit to staying the course.
The Volatility Trap
The Volatility Trap, portrayed in Figure 1, captures the dynamics of market volatility and return over time. Time zero, the present, separates the recent past (the left side of the figure) from the near future (the right). While the stock market has just been through a period of high volatility and below-average returns, the right side represents a near future in which volatility is typically lower and market returns are above average. We will demonstrate that markets routinely work this way.
The emotional reaction to volatility turns this into a trap.
The Volatility Trap is driven by the empirical observation that, even though investors have recently suffered increased volatility and lower or even negative returns, future volatility will most likely lessen and market returns will often be above average. (This is common sense which is often forgotten in the heat of the moment – abnormally high volatility must at some point revert to more reasonable levels, just as below-average returns must rise.) As strong as is the urge to bolt the market, the rational decision is to stay the course or even increase equity holdings. If the investor falls into the Volatility Trap by abandoning the stock market, they compound their misery by missing out on higher future returns.
Resisting the impulse to decrease market exposure in the face of increased volatility is counterintuitive, of course. It cries out for empirical support, a task to which we now turn.
Market volatility and returns
In order to explore the relationship between market volatility and return represented in figure 1, we gathered weekly values for the S&P 500 index from December 30, 1927 through October 14, 2011. For each week, we calculated trailing 4-, 13-, and 26-week standard deviations – our measure of weekly market volatility. For example, this resulted in 4,382 estimates of the trailing 13-week, weekly standard deviation. The average trailing 13-week, weekly standard deviation was 2.16%, reaching a low of 0.41% on 4/10/1964 and a high of 9.52% on 10/07/1932. The most recent value (10/14/2011) was 4.39%.
We then calculated subsequent 1-, 4-, 13-, 26-, and 52-week S&P 500 price changes (excluding dividends) in order to explore the volatility-return time dynamic of the S&P 500.
For historical perspective, the annual average 13-week, weekly standard deviations from 1928 through 2011 are displayed in figure 2 below. The 1930s experienced the worst market volatility, with every year at or well above the long-term average of 2.16%. Volatility then declined somewhat during the 1940s, 1950s and 1960s. From the 1970s on, weekly volatility reached a higher plateau, and 1974 and 2008 were particularly volatile. In 2010 and 2011, volatility has been a bit higher than average, but the last two years have not seen exceptional weekly volatility by historical standards.
Recent market volatility versus recent market returns
Volatility is usually associated with market losses, and the current period is no exception. Since April 29 the Standard & Poor's 500-stock index has fallen by 17.6% — not far from the 20% drop that defines a bear market.
The Wall Street Journal, October 5, 2011
Nobody enjoys volatility. When it is combined with a large market loss, it is doubly painful. Highly emotional events are more likely to be remembered, so it is not surprising many investors believe, as the writer states above, that “volatility is usually associated with market losses.”
But what does the data tell us? In order to find out, we calculated the average 4-, 13-, and 26-week S&P 500 price changes and matched them with the same-period standard deviation. Figure 3 reports these averages in three groups: lower, middle, and highest standard deviations from 1928 through 2011.
The results confirm the conventional wisdom: Average returns correlate inversely with volatility. In fact, the average price changes were negative for the highest volatility in each sample. The “recent past” aspect of the volatility trap is accurate, as we can see in Figure 3; higher volatility is associated with lower returns.
Fighting the urge to bail
We just showed that there is a strong inverse relationship between recent market volatility and returns: when volatility increases, returns go negative. No wonder investors are ready to bail as they suffer the dual ignominy of nerve-rattling volatility and declining portfolio value.
Putting emotions aside, however, the question is whether rising volatility is a reliable signal for future volatility and returns. If it is, then it can be used to build superior portfolios. If not, then it should be ignored when managing a portfolio.
To test our hypothesis, we regressed subsequent weekly standard deviations (our measure of future volatility) on trailing weekly standard deviations (our measure of recent volatility). The resulting slope coefficients are reported in figure 4. A value less than 1.0 means that future weekly volatility is, on average declining.
A slope coefficient that is less than 1 means high levels of volatility will not persist, and it is possible for future volatility to remain above average. That said, the recent-future volatility relationship holds for each recent-future combination, as the data show in Figure 4, supporting the expectation that volatility will tend to diminish – regardless of how long it has persisted.
Next, to test whether volatility signals higher future returns, we regressed future S&P 500 price changes on trailing weekly standard deviations. As we can see in Figure 5, below, 90% of the coefficients are positive, which means that, historically, the higher the recent volatility, the higher were future returns. During the time period we examined, a one-unit increase in 4-week standard deviation predicts a 0.03% increase in 4-week price change. Over more recent time horizons – 1950-2011 and 2000-2011 – a one-unit increase predicts a substantially higher 0.12% and 0.17% increase, respectively.
In other words, future expected returns have risen with an increase in recent volatility, and this relationship has grown stronger over time.
To see this another way, Figure 6 depicts future annual S&P 500 returns from 1950-2011, broken down by recent volatility. When recent volatility has been low, the average future return is 9.6%, and when recent volatility is high, the average future return is 12.0% – further evidence that recent volatility and subsequent returns enjoy an inverse correlation. This is also consistent with results reported by Bollerslev, Tauchen, and Zhou.
Staying the course
The data show that the Volatility Trap is not just logical, its observable. High volatility may be accompanied by low and even negative returns, but it is also predictive of lower future volatility and above-average future returns. Though it may be understandable that the joint pain of high volatility and lower returns might increase the urge to bail from the market, investors who do so miss out on the other side of the equation – higher future returns. Emotional decisions are costly.
The Volatility Trap provides no relief for the investor over time. Let’s say that you have just suffered through four weeks of high market volatility and negative returns, and you are ready to run for the hills. To avoid the Volatility Trap, however, you stay the course in hopes of seeing the predicted lower volatility and high returns.
Instead, volatility worsens and your losses mount. After all, actual results can be much worse or better than expected. At 13 weeks, you are thinking ‘enough is enough’ and prepare to exit the market. Again the evidence reveals that, even though the pain has continued, the empirical facts have not changed: the data still show that future volatility should decline and returns should rise. With great trepidation, you relent and stay the course. You continue to take a pounding, and after 26 weeks you are at wits’ end. Still the Volatility Trap provides no solace – the evidence still says that most likely things will get better. Thinking that you do not want to miss out when the market turns, you reluctantly stay the course. Boy, is this fun!
There is no time limit to the Volatility Trap. No matter how long recent volatility lasts, the best decision for most investors going forward is to stay the course. In this regard, the Volatility Trap ensnares both rational and irrational investors. The rational investor suffers through all of the indignities thrown at him or her by the market in order to earn the highest possible long-term return, while the irrational investor ends up with an inferior portfolio because he or she bolted the market in times of high volatility. The market does not make it easy to be a successful equity investor.
We believe that the relationship between low recent returns, high future returns and recent volatility is driven by investor behavior. The low recent returns are the result of emotional investors leaving the market as volatility rose, which drives down prices and returns. The higher future returns result when these same emotional investors quit selling or begin to move back into the market. To take advantage of these swings, an investor must be more rational than his or her counterparts in the marketplace. Such self-control is essential to earning the best long-term returns.
While emotions are part and parcel of human nature, responding to gut-wrenching volatility by exiting the stock market, as did Mr. Gerber and millions of other investors, hurts both short-term and long-term portfolio performance. At the very least, investors should stay the course in the face of rising volatility, and maybe even increase equity exposure.
Once we put the initial, instinctive anxiety in perspective, we can see rising volatility for what it is: an opportunity, not something to be feared.
C. Thomas Howard, Ph.D. is a professor emeritus at the Daniels College of Business, University of Denver and CEO and Director of Research of AthenaInvest Advisors, LLC. Craig T. Callahan is the president
ICON Advisers, Inc.
Read more articles by C. Thomas Howard, Ph.D. and Craig T. Callahan
