Should You React To The Surge In Stock Market Volatility?

The coronavirus that’s roiling world markets and raising questions about the economic outlook has triggered a familiar shock to stocks: higher volatility. Is this a reason to change your asset allocation, rebalance the portfolio or modify risk management decisions? Maybe, but maybe not. There is no generic answer for everyone because every investor is different due to risk tolerance, time horizon, investment objectives, and so on. But while customized advice and analysis isn’t appropriate here, it can’t hurt to review some basic points for volatility as a risk metric.

The first observation is that risk has surged recently for US stocks. For example, volatility (standard deviation) of daily returns for the S&P 500 Index (based on the rolling 30-trading-day window) jumped to 30% yesterday (March 4)—the highest since 2011.

The question is whether this is noise or signal? As always with financial markets, there’s a bit of both in the numbers. Unfortunately, untangling one from the other is challenging. Nonetheless, there are hints that there’s a relationship here. For example, note the negative link between volatility from six months previous (126 trading days) with current 1-year trailing return for the S&P 500. Yes, it’s noisy and this profile alone isn’t particularly reliable at any one point in time. That said, there’s a general tendency for spikes in vol to be followed with lower/negative performance for the trailing one-year window down the road.

Is this profile (and others like it) relevant information? Perhaps. A number of research studies over the years document empirical support for using volatility as an input for risk management. An article in The Journal of Finance in 2017 “Volatility‐Managed Portfolios,” for instance, found:

Managed portfolios that take less risk when volatility is high produce large alphas, increase Sharpe ratios, and produce large utility gains for mean‐variance investors. We document this for the market, value, momentum, profitability, return on equity, investment, and betting‐against‐beta factors, as well as the currency carry trade. Volatility timing increases Sharpe ratios because changes in volatility are not
offset by proportional changes in expected returns. 

Although you can find a number of studies offering encouraging results for using vol as an input to a risk management strategy, skeptics will correctly note that the real-world portfolios that have succeeded on this front – with verifiable performance data – are the exception.

Perhaps the bigger threat is letting recent market activity turn you into a sudden convert to vol-managed strategies. If you suddenly find yourself in the vol-is-useful-for-risk-management camp after volatility has spiked, that may be a sign that you’re letting behavioral factors influence your decisions.

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The good news is that monitoring volatility and studying its history still has merit even if you’re not inclined to fish in these waters. Understanding that vol can spike and possibly lead to softer/negative returns for the near term helps you prepare by managing expectations. Volatility spikes are inevitable in the stock market (and other asset classes). It’s debatable if you should use this information to manage the portfolio.

Regardless, the worst-case scenario is allowing vol spikes to make investment decisions for you based on emotion. The antidote is studying the history of vol for the assets (and portfolio) you own. That’s not a silver bullet, but it’s the basis for anticipating what may be coming and for understanding that at some point this too shall pass.

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