When Market Volatility Returns with a Vengeance

Wall Street has a bad case of the downers lately. With triple-digit drops in the Dow one day and double digit jumps the next many investors chose to take shelter on the sidelines as they pried open a bottle of Pepto.

The picture is not pretty: As of August 10th, investors could only stand back and watch as the S&P 500 Index continued a 20-day trading sell-off resulting in a 14% loss. So what does it mean and what should we do about it when the market as a whole suggests that the value of a broad index of U.S. companies is 14% less today than a month ago?

How Bad Is It?

The first thing we need to do is to put this drop in context.

We’ve seen worse and lived to tell the tale. However, no one wants to re-live the week-long financial meltdown of October 2008 where the DJIA began a week-long slide that cost investors 2,399.47 points and -22.11%. Prior to 2008, we experienced 20-day losses—at this level or worse—back in 2001 and in 2002.  Before that, we need to go back to the very volatile year of 1987 to see comparable losses on the same scale.

It’s interesting to look at the aggregate statistics on market returns over the entire period from August 10, 2011 back to the early 1950s. Over this 60-year period, the annualized volatility of the returns of the S&P 500’s is 15.4%.  The average annual return for the S&P 500 is 8.04% (before we account for dividends). 

Annualized Volatility of the S&P 500 Index

This chart is worth spending some time on and has important implications for investors.  First and foremost (on even an annualized time scale) what we have experienced so far this month is still a small blip compared to 2008-2009 which was the last real peak we had seen in terms of volatility.

It’s clear to see that 1987, 2001-2002 and 2008 are the major historical peaks in volatility in the past 60 years. The chart above is consistent with the earlier observation that the only times in the recent past that we have seen declines as fast as we have experienced in the last month were in these major bear markets.

We can clearly see that even though the historical average volatility of the S&P 500 has been around 15%, the level of market volatility varies dramatically from year to year. The current trailing 1-year volatility for the S&P 500 is 17.2%.

So, what can we expect in the future?

Volatility is Back

The best estimates of future volatility can be found in the options markets.  The prices of options on a stock, ETF or index reflect the market’s consensus view of future volatility.

The volatility that we back out of options prices is called implied volatility. As of this post, options on SPY, an S&P 500 ETF, which expire in 1-3 years have implied volatility of around 27%. What the options markets are telling us is that we should all expect higher-than-historical-average volatility for the next few years.  Even before the recent run-up in volatility, the options market was signaling a higher future volatility. In July, the implied volatility of  long-term options on the S&P 500 hovered around 20%—which is about a third higher than the long-term historical average.

Another way to look at historical volatility is through the VIX index.

Get Acquainted with the ‘Fear Factor’ Index

VIX measures near-term implied volatility which is the level of volatility that the market expects in the near term on the basis of options prices. The VIX index was launched in 1990 so we don’t have data before that time. VIX is often referred to as the “fear index” because investors tend to buy options, pushing up VIX, when the market is falling.  If investors are becoming risk averse,VIX  rises and vice versa.


 

 

 

 

 

 

 

 

Trailing 1-Year Volatility and VIX

We can see that there is a broad correspondence between trailing market volatility and VIX, but VIX has much more information about sudden market shocks.

By using VIX, we can see that it shot up in August—reaching levels not seen since early 2009.  As volatility increases, the probability of a very large daily loss also increases and this is exactly what we are experiencing right now.  Market volatility—historical, long-term expected, and short-term expected—is well above historical long-term averages. Since the start of October 2008, both trailing 1-year volatility for the S&P 500 Index and VIX have averaged 28%, well above their long-term averages. And the options markets are suggesting that expected volatility will land somewhere near 27%, as I mentioned before.

What Investors Need to Do Now

There are a number of implications we can draw from these market conditions. First, we need to come to terms with the fact that long-term volatility is here to stay. Be prepared for long-term volatility that’s significantly higher than the long-term (50-year and 20-year averages) for the stock market. No one can really know why we are expecting higher-than-usual volatility, but the current state of uncertainty in the U.S. economy and global marketplace doesn’t help matters.   And as we’ve seen just this past week, uncertainty leads to higher expected volatility.

Understand the Changing Landscape of Risk

For investors who are focused on long-term goals like retirement, it’s very important to understand what a higher-volatility market means. First, get used to experiencing these gut-wrenching drops in valuations. This can pose a challenge for investors’ emotional ability to handle big swings in the value of their portfolios.

However, another more fundamental issue needs to be understood here.  When investors choose how they will allocate their retirement savings, they are also identifying how much risk they’re willing to take.  The problem that arises today is that the risk level (volatility) associated with any given asset allocation changes through time and we are seeing some evidence that suggests that the risk levels associated with every asset class have increased—and are likely to stay above their historical levels.

For example, while you may have chosen a portfolio made up of 60% stocks and 40% bonds based on the historical risk-return characteristics of this allocation, the market is indicating that a 60/40 portfolio is likely to be riskier in the coming years than it has been in the past.

Plan Ahead for a Bumpy Ride

Investors can respond to this shift in risk by either steeling themselves for more volatility, or by changing their asset allocations. The purpose of asset allocation is to maintain a targeted risk level, but if that risk level changes, investors and their long-term goals need to change with it. Now’s the time to take a long, hard look at your portfolio, decide how much risk (i.e., volatility) you can stomach and adjust your portfolio accordingly.

When we designed our Target Date Folios more than 3 and a half years ago, we established risk targets for each of them. In a comment letter to the SEC, Folio Investing made the case that managing Target Date Funds and strategies against a planned risk level made more sense than managing to a specific asset allocation precisely for this reason: risk levels change through time.

At the end of 2010, we adjusted the asset allocations of our Target Date Folios in response to a market environment in which almost every asset allocation was expected to be riskier than it had been in recent decades. This process is referred to as risk budgeting and represents a new standard for long-term planning. As a result of our periodic analysis and adjustment, we expect Target Date Folios to be well-positioned for a higher-volatility future.

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4 thoughts on “When Market Volatility Returns with a Vengeance

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