Volatility: measure or target?

Hi there, Boaz is away and so I’m filling in for the next few days. I want to tell you about something that has been making me incredibly nervous since I found out about it over a month ago.

Aside from being an investment research analyst, I am also a qualified ski instructor. One of the interesting dimensions of seeing people develop as skiers is their attitude to risk. Skiing is an ‘extreme sport’ after all.

The perception is that as you get better at skiing, the risk decreases. Good skiers quite often forgo helmets, under this false pretence.

In fact, the truth is that the better you get – the faster you will go, and the more confidently you will approach risky situations. So with each stage of development, the nature of risk changes.

Beginner skiers fall often, and are very rarely harmed, as speed is low, and the slopes are flat.

Advanced, overconfident skiers take more risks at higher speeds under the illusion that ‘risk’ has fallen because they fall less often.

In fact, the opposite is true.

Risk has increased, despite fewer falls. The severity of a fall on steeper slopes at higher speeds is dramatically increased. The human body can take lots of small shocks. It’s the big ones that cause permanent damage.

A lower frequency of risk does not mean lower risk. An illusion of safety can actually enhance risk.

When I am teaching or guiding, my job is to make guests aware of this, and to prioritise safety above all.

As I write to you today, my job doesn’t feel so different.

The markets are like an advanced skier.

A long period without any small crashes has created an illusion of safety, leading to greater risk taking. But the lower frequency of falls has created a situation where the next one will be severe.

What am I talking about? Volatility.

Volatility is a measurement which tells investors how much the price of an asset fluctuates.

For want of a better option, investors have been using volatility as the sole measure of risk for a number of years.

Currently, volatility is at an all-time low, and this makes people think that the markets are safe and stable.

This is an illusion.

In fact, low volatility will be the biggest threat to the markets once the next increase in volatility comes.

Another analogy.

As a keen skier who spends a lot of time off-piste and in the backcountry, away from the resort, I have seen, and even been taken up in multiple very small avalanches. I’ve also seen the tracks of much bigger ones.

I often wonder what the final cause of an avalanche is. Is it the weight of the final snowflake to fall, a gust of wind, or a tremor deep within the mountain?

With an avalanche, you can see risk factors building – steep slope, high wind, heavy snowfall, changes in temperature, north/east facing.  But you can never know what final cause was, or will be.

And so, counter-intuitively, avalanche safety teams regularly set off avalanches. Not just small ones, but big ones too. They do this to clear away a lot of small build ups of snow on the mountain, which could easily be triggered by a single winter sports enthusiast. In this way, more avalanches equals less risk.

This is recognition that if risk factors are allowed to build up, they will cause something worse

This is the opposite of the forest fire fallacy, in which preventing lots of small forest fires eventually leads to a build-up of burnable debris and foliage, resulting in a much bigger fire.

This compares again to volatility in the markets. It has been decreasing steadily since the financial crash. The attempts of central bankers and CEOs to achieve ‘steady’ growth, has prevented small corrections along the way.

Think about that word correction – why have I used it?

Because it implies that the market is wrong, and needs to be put right.

The investing idea of ‘buying the dips’ because of the long term uptrend of markets has been sufficiently widely adopted that small tremors in the markets have been quickly seized upon by ‘savvy’ investors. Thus, instead of bad results, bad news, and bad policies causing markets to decline, they have been seen as ‘opportunities’. And so, every time markets have stumbled, they have been very quickly picked up.

There have been no forest fires. The debris has not been cleared. The snow pack is building up. Volatility is not going to cause the next downturn. But it is going to take the next downturn, strap some gold bars to its ankles, and throw it off the nearest cliff.

The Genesis of the problem

In financial markets, ‘volatility’ is the word used to describe the extent of movement in the price of an asset. Or at least that’s how it was originally used. Now it’s been mistakenly translated into a measurement of risk.

Volatility comes from the latin word volare meaning to fly. This is ironic given that markets relentlessly dragged volatility down since the financial crisis.

The irony is clear. Believing that volatility equals risk, and trying to reduce it, has led to one of the biggest risks in the financial markets today.

Risk cannot be removed, changed or reduced – only moved around. This was highlighted in the crash of 2008. Securities designed with the stated goal of spreading and therefore reducing risk (groups of risky mortgages packaged together under the assumption they wouldn’t all default at once), exacerbated it immensely.

A similar thing is happening today.
It’s called the short volatility trade, and it has three distinct parts to it.

Tomorrow I’ll be back to see why risk management could just be the riskiest thing to be happening in the markets today.

Not all markets will be equally affected by this. My colleague James Allen has been working on one of the most resilient markets during difficult periods. In fact, I expect his recommendations to do brilliantly regardless of conditions in the major markets.

That’s because his expertise has unearthed some seriously great niche opportunities.

The gains on offer are extraordinary.

Go here to find out more

Many thanks,

Kit Winder
Capital & Conflict

Category: Financial Glossary

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