Back to basics: Volatility
All investments carry a degree of risk. Equity investors, for example, are up against the risk of fluctuations in the market price of shares. In the investment world, these fluctuations are referred to as market volatility; the larger the fluctuations, the higher is the deemed volatility.
1. WHAT IS VOLATILITY?
An equity investor can refer to the CBOE Volatility Index (VIX) which measures investors' expectation of the volatility of the S&P500 Index. As per Fig. 1, the blue line shows the average market volatility over the past 10-year period. The big spikes in the volatility index can be attributed to periods of risk aversion due to a variety of reasons such as the 2008 Global Financial Crisis ("GFC"). Since 2012, market volatility has generally been below the 10-year average despite the occasional spikes. Throughout 2017, volatility was at record lows and only rose in February 2018 following rising inflation fears. It has since receded.
2. WHAT AFFECTS VOLATILITY?
Although volatility is inherent in investments, during periods of economic, political and financial crises, it goes up significantly as seen in Fig. 1. The past two decades have been marked by bouts of volatility triggered by such crises. Furthermore, where previously economic and financial crises used to be few and far between, they now occur much more frequently. For example, the 2008 GFC struck barely a decade after the early 2000s' dot-com crash, which in turn happened just a few years after the 1998 Asian Financial Crisis. These events were mostly unrelated to each other but they underscore the unpredictability and inherent volatility of markets.
Volatility can also be triggered by expectations or even rumours as a result of human nature and behavioural biases that have been shaped by good and bad experiences. Hence when markets are rising, the greed factor kicks in and when markets fall, fear sets in. Such swings in emotions can cause investors to engage in irrational buying and panic selling which in turn increases the volatility.
3. VOLATILITY OF MARKETS
While the VIX can be used to measure the expected volatility of the S&P 500 Index, the standard deviation is a commonly used measure of the historical volatility of equity markets. Put simply, this measure shows how much an investment's return varies from its average return over a certain time period. This measure is useful when comparing across and within asset classes and helps investors make informed choices.
Historically, Asian and Emerging markets are more volatile than the developed markets such as US and Japan. However, this does not mean that investors should avoid these markets. Diversification, including exposure to low volatility strategies can give investors exposure to attractive opportunities in these markets, minus the extreme swings in prices.
Sources: 1Thomson Reuters Datastream, Chicago Board Options Exchange as of 12 June 2018. 2Bloomberg as of 14 June 2018.
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