Tag Archives: market volatility

Goodhart’s Law

Goodhart's LawGuest post by Leo Chen, Guest Contributor to Cumberland Advisors.

Goodhart’s Law

“When a measure becomes a target, it ceases to be a good measure.”

-Charles Goodhart

When it was first introduced in 1975, Goodhart’s Law focused mainly on social and economic measures. Since then, many financial market indicators have lost their forecasting power and succumbed to Goodhart’s Law. Nevertheless, Goodhart’s Law in no way depreciates the value and importance of market indicators; it simply means that investors are unlikely to be able to consistently generate abnormal returns over time using popular measures that are publicly available to the entire market. A clear example is what has happened to the CBOE Volatility Index, or VIX.

The Volatility Index

The Volatility Index (VIX) was a groundbreaking product when the Chicago Board Options Exchange (CBOE) released it in 1993. Also referred to as the fear index, VIX measures the expected underlying volatility in the S&P 500 over the next 30-day period on a real-time basis. Using various measures of VIX such as the two-week mean, the 30-day rolling standard deviation, etc., VIX traders and portfolio managers developed strategies that were initially profitable. However, over time it has become extremely difficult to profitably forecast the market by simply observing the movement in VIX.

While the history of the VIX demonstrates how a market gauge lost its predictive power once it caught investors’ attention, the CBOE Low Volatility Index, LOVOL, provides an even better illustration of how an indicator can lose its forward-looking power very quickly. CBOE began calculating the Low Volatility Index on March 21, 2006, and started disseminating LOVOL data on November 30, 2012. The forecasting ability of LOVOL immediately plunged to almost zero within a month. In fact, Goodhart’s Law has captured nearly all of the CBOE volatility indexes as prisoners. These fallen angels are no longer useful tools for forecasting purposes.

Another prominent index, developed in the late 1960s, that uses extremes in its value to signal that a market may soon change direction is the Arms Index (TRIN). As predicted by Goodhart’s Law, while technical indicators such as TRIN were able to successfully predict market returns in the past, their loss of forecasting power was only a matter of time when every technician used these ratios for trading purposes. Even the Federal Reserve was no exception. The pre-FOMC announcement drift was found to explain the equity premium puzzle in 2011. But this 24-hour window disappeared soon after the research was published.

Investors Beware

On one hand, Goodhart’s Law teaches us that a smart investor should not rely on any single factor known by the general public to be “powerful”; on the other hand, it does not negate the significance of any indicator.

The following figure is a ratio brought up by Chairman and Chief Investment Officer David Kotok of Cumberland Advisors. The CBOE SKEW Index measures S&P 500 tail risk, while the VXTH Index hedges “black swan” events such as Black Monday in 1987. Lagging and scaling both indexes by the lagged VIX, we are able to track the daily SPX with a correlation that can top 90%, comparable to the correlation between the S&P 500 and GDP. Nonetheless, a high correlation is not necessarily equivalent to strong forecasting power. While one could use this chart for long-term investing strategy, the accuracy of using these daily ratios to predict the daily market movement is approximately 51%, not economically significant enough for forecasting purpose.

3-5-2015

Figure 1. Correlations between SPX and Volatility Indexes

Conclusion

The list of captives of Goodhart’s Law is clearly longer than just the indicators mentioned above. High-quality research should be able to produce positive abnormal returns as long as there is information that can be exploited; however, superior research alone is no longer synonymous with outperformance – time is also of the essence. Because of technological innovation in financial markets, the time frame in which Goodhart’s law operates today is much shorter than it was in earlier decades. Just as Moore’s Law predicts that chip performance will double every 18 months, investing methodologies must continually evolve in order to remain profitable, due to Goodhart’s Law.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Cumberland Advisors is not affiliated with Folio Investing or The Portfolioist.

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Sector Watch: Spotlight on Defensive Strategy

About four and a half years ago, Folio Investing launched an equity (e.g. stock) portfolio that focused on reducing the impact of market volatility.  So-called defensive stocks are those which tend to be fairly insensitive to the mood of the market as a whole.  Conventional wisdom suggests that demand for band-aids, electricity and paper does not go up when the market is exuberant, but neither does it collapse when the market swoons.  The conventional wisdom also suggests that these stocks will tend to under-perform the broader market during rallies and, over the long-term, that a portfolio of these stocks will deliver modest returns.  Our research suggested, however, that it was possible to create a portfolio of defensive stocks that would provide returns to keep up with rallies in the broader market, while still substantially reducing the impact of market volatility.  Folio Investing launched the Defensive Strategy Folio that incorporated this research on February 28, 2008. Continue reading

Expect More Huge Daily Market Swings

As I write this on November 26, the S&P 500 Index is down by about 4.6% for the week. The S&P 500 dropped 1.9% on November 21st and then dropped 2.2% on November 23rd. These are enormous daily drops. 

Something has happened that has convinced the aggregate of market participants that the total value of every company represented in these indexes is suddenly worth about 4.6% less today than they were worth a week ago.  What terrible news has led to this reduction in the value of these hundreds of firms? 

Nothing concrete, really.  Continue reading

Q3 2011: Another Test for 2010 Target Date Funds

The third quarter of 2011 was impressively bad.  The S&P 500 Index lost 13.9% for the quarter.  The VIX, the standard measure of market volatility, repeatedly closed above 40 during this quarter. To put this in perspective, the average daily closing value of VIX from the start of 1990 through the end of September 2011 was 20.5. The average daily closing value for VIX during Q3 of 2011 was 30.6. 

Many critics of Target Date funds felt that these funds lost too much during the bear market in 2008. Special attention was focused on 2010 Target Date funds, funds designed for investors planning to retire in 2010. The poor performance of these funds even got the attention of the SEC, which proposed new disclosure standards. Market observers (including the SEC) noted that 2010 Target Date mutual funds lost an average of 24% in 2008. In light of 2008, many funds redesigned their asset allocations to be more resistant to massive market declines. 

Now, let’s flash forward three years. Continue reading

“A Little Late” by Carl Richards

Carl Richards’ is a favorite contributor here at the Portfolioist. We’ve interviewed him in the past (see, “How to Pick an Investment Advisor (Part 3): Carl Richards’ 3 Key Questions” by Nanette Byrnes) and remain a fan of his website, behaviorgap.com.

Using a Sharpie and a piece of card stock, Richards captures complex financial ideas in simple, easy-to-understand sketches.

Here’s his latest sketch and commentary on the recent market volatility. Enjoy–we certainly did. Continue reading