Busting the myth that this is a high volatility environment

 

The assertion we are in the midst of a volatile equity market environment has become a common headline in the popular press.  The facts, however, suggest otherwise.  I’d like to add the claim “these are volatile times” to the list of myths that need to be busted.

Let’s start with the data: the usual measure of expected equity market volatility is the VIX index¹. As of June 16th, that index stood at 12.65—even with the sizable increase in volatility on Monday in response to the brewing crisis in Iraq.  That’s nearly 40% below its ten-year average and around the 16th percentile of all data points over that time period (in other words, expected volatility has been higher than it is today ~85% of the time over the last decade.)

The VIX is a forward-looking measure.  What if we consider actual experience (or what is referred to as realized volatility)?  Well, we reach the same conclusion. Over the first five months of 2014, the volatility of the Russell 1000® index was (annualized) 11.7%. That’s low by historical standards: the annualized volatility of daily returns averaged around 20.5% over the last ten years (2004-2013), and over the prior ten years (1994-2003) around 19.3%.

So the data does not support the high volatility for equities claim. Like most myths, however, there is a sliver of truth that lies behind this one. There is uncertainty regarding significant macro economic and political policy issues which could lead to an increase in volatility at some point in the future. Uncertainty that could lead to increased volatility is quite different than the equity markets being volatile today.

Why should we care if current market volatility has been mischaracterized?  Calling a low volatility environment a high volatility environment can distort our interpretation of our risk tolerance—a key input into selecting a strategic policy portfolio.  In short, we can be lulled into a sense of complacency. This may result in holding a risky portfolio when we really do experience a volatile market.  When this happens, some investors will become reluctant to rebalance the portfolio and thus miss out on a subsequent rebound. Others will commission a new asset-liability study and subsequently adopt a less risky portfolio which, while couched as a strategic decision, is really a reaction to the portfolio being more risky than they were prepared for.

The point is that some day in the future, we will look back fondly at these markets as particularly low, not high, volatility. And  when we do experience higher volatility, it will feel nothing like it does today.

Note: One of the nice things about working at Russell is the sabbatical program—a chance to take a prolonged break after each ten years of service. As a result, Bob Collie shall be away from the office until late July. The Fiduciary Matters hot seat will be filled by guest authors over that period.  Do make sure to provide comments in the space provided if you especially like or dislike anything we do or say. 


¹CBOE and VIX are registered trademarks of the Chicago Board Options Exchange
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