If you’ve ever paddled a canoe on a calm lake only to get caught in a sudden squall of rough waves, then you’ve experienced volatility. When it comes to investing, volatility occurs when a “storm” develops rapidly and sends prices shooting up or down in a dramatic fashion. Few investors complain when the volatility is in the upwards direction, but they certainly do mind when volatility moves against them as it can rapidly wipe out previous gains.
The technical definition of market volatility is a measure of price variance around a mean over a period of time. Using the example of paddling a canoe, volatility measures the size of the waves. The bigger the wave, the higher the volatility
One measure of volatility is the VIX Index which measures implied or expected volatility of the S&P 500 over the next 30 days. The VIX is also called the “Fear Index” because it delineates investor uncertainty. The VIX can stay below its average value for long periods of time and then spike suddenly due to market events. This happened in 2008-2009, and, more recently in 2020 due to the Covid-19 pandemic. By way of illustration, between February 19, 2020 and March 23, 2020, the S&P 500 fell almost 34 per cent. During the same period, the VIX Index jumped from 14 per cent to 62 per cent. (It reached a high of 83 per cent on March 16th when the S&P 500 fell 12 per cent.)
Regular market drawdowns are a feature, not a bug, of equity markets. However, even the most experienced investor cannot reliably time when these market shifts will occur. There are several investment strategies that reliably dampen excessive volatility.
Diversification is one such strategy and it is an important part of a well-built portfolio. Active management is another effective way to “tame” markets. No one can reliability predict when significant volatility will occur, yet, late in the market cycle it is prudent to employ protective strategies. Active management is not the same thing as trying to “time the market” by shifting assets into low risk investments, thus missing almost all of upside late in the market cycle. Instead, active management is a defensive strategy that seeks to “tame-the-market” as part of a longer-term investment plan. “Taming” allows the investor to benefit from reasonable returns while, at the same time, lowering overall volatility. When growth opportunities arise, the portfolio again tilts toward equities. Options writing strategies can be an extremely useful adjunct in “taming the markets”.
During bull or sideways markets, volatility tends to be low. However, as we have seen, when prices drop suddenly investor uncertainty increases dramatically. There is a saying on Wall Street: “Stocks take the stairs up and the elevator down.” Another popular saying is, “The market can stay irrational longer than you can stay solvent.”
That is why risk management is key in protecting portfolios from excess volatility. A smoother ride helps investors sleep-at-night and stay invested through market cycles.
Disclaimer: Past performance is not predictive of future returns. Returns for the S&P 500 Index are presented in their local currency with reinvested dividends.