Volatility strikes back

19 March 2018 | Markets and Economy


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When volatility returned to global equity markets earlier this year, headlines cast this statistical concept in its familiar role as investors' most fearsome enemy.

But volatility may be getting a bad rap. It's not a villain, and it's not always synonymous with portfolio losses.

A closer look at the concept can help us understand what volatility is, why we shouldn't expect a premium for holding equities without it, and how investors can manage their emotions when volatility takes centre stage.

Volatility is not directional

A common misconception about volatility is that it implies direction and that, therefore, lower volatility is preferable to higher volatility. In reality, market volatility metrics are simply measures of dispersion around the average return, providing no insight into direction. A used automobile is an incredibly low-volatility asset in that it steadily declines in value over time; that doesn't make it a good investment. In fact, outside of the mobility benefits it provides its owner, it is the very definition of a poor one.

An investment's recent returns determine whether volatility marks a change for the better or the worse. In recent years, equity prices have marched steadily higher. In this situation, a few instances of negative returns will have a larger impact on volatility metrics than will positive returns of the same magnitude. By contrast, during a period of steady equity market declines, a few days of positive returns will produce a spike in volatility. The figure below demonstrates how two different portfolios with opposite performances can produce identical volatility measurements.

Two portfolios, identical volatility

Two portfolios, identical volatility graph chart

Notes: Figure shows hypothetical return simulations for two portfolios. Volatility is calculated as the 10-day rolling standard deviation of daily returns. Source: Vanguard.

As you might expect, the longest continuous period of above-average market volatility1 since the Great Depression occurred during the 2008 global financial crisis. What you might not expect is that if you bought the S&P 500 Index at the peak of its volatility (21 November 2008) and held it until volatility fell back below its historical average nearly a year later (28 September 2009), you would have earned a 33% return, even before accounting for dividends. (Note: Past performance is not a reliable indicator of future results.)

Ignorance (toward volatility) is bliss

Investors must remember that short-term volatility is the price for long-term outperformance.

Historical data show that over long periods, investors are compensated for holding riskier assets with higher returns than those of less risky assets. Daily account balances may start demonstrating larger fluctuations than in recent years, but long-term investors must resist the urge to make impulsive changes to their investment plans. As Nobel laureate Daniel Kahneman said, "If owning stocks is a long-term project for you, following their changes constantly is a very, very bad idea. It's the worst possible thing you can do."2   Mathematics explains why.

As mentioned above, stock market volatility explains how often and by how much equity returns differ from their average value. The mechanics of the calculation mean that while investment returns increase in proportion to time, volatility increases more slowly – in proportion to the square root of time.3

The upshot is that the less frequently investors peek at their portfolios, the less likely they are to see a loss and, potentially, feel fear and regret. The table below demonstrates this phenomenon using daily S&P 500 Index returns. Notice how returns grow at a faster rate than standard deviation of returns, a.k.a. volatility, and that as time goes on, the likelihood of realising a positive return increases.

Time horizonMedian returnStandard deviation of returnsPositive return probabillity
One day 0.06% 1.10% 54%
One week 0.35% 2.27% 58%
One month 1.29% 4.19% 64%
One year 13.69% 16.50% 83%
Ten years 119.01% 137.45% 91%

Sources: Vanguard calculations, using data from Bloomberg. Dates: 4 January 1988–16 February 2018.

Once again, this highlights the importance of a long-term focus when investing, as any single day offers just better than a 50% chance of positive returns. Investors who ignore short-term volatility and follow a disciplined investment plan will realise that when it comes to long-term returns, time is on their side.

1 Volatility in this example is defined as the rolling 30-day standard deviation of price returns for the Standard & Poor's 500 Index, with the historical average taken from March 1928 through February 2018.
2 Zweig, Jason. 2001. Do You Sabotage Yourself? Money (May 2001): 78
3 The square-root-of-time rule is a useful, but not perfect, method for scaling volatility. Observed data differ from the model's assumptions of normally distributed returns and zero mean value.

Investment risk information:

Past performance is not a reliable indicator of future results. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Important information:

This document is directed at professional investors in the UK only, and should not be distributed to or relied upon by retail investors.

The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.

This article was produced by The Vanguard Group, Inc. It is not a recommendation or solicitation to buy or sell investments.

The opinions expressed in this article are those of individual author and may not be representative of Vanguard Asset Management, Limited.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.


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