How to use volatility to navigate markets

Volatility can give investors insight into whether market conditions are ripe to support a rising market or whether investors should strap themselves in for a roller coaster ride.

When something is volatile, it is prone to explode. Volatility means big moves. When volatility spikes, it’s time to hang on tight, and perhaps even shut your eyes! You’re in for the roller coaster ride called the ‘share market’.

How do we define volatility in the share market?

In the Australian sharemarket, we have the AVIX as an indicator, with the code XVI.

The AVIX index started in 2008. The top 46 readings have all been in 2008 between 9 October 2008 and 17 December 2008.

With high volatility comes falls in the market, with the Australian sharemarket (S&P/ASX 200) falling 17% during that period.

Bad negative returns tend to cluster. Even the big positive return days happen among a cluster of negative ones. Don’t be fooled if the market starts to see big positive returns alongside negative returns. This is usual and signals that more volatility can be expected.

Spikes in volatility occur on a regular basis as can be seen from this 12-year chart:

Spikes in volatility usually mean losses for the market. In the three periods circled in red on the chart, each of these years saw negative returns from the S&P/ASX 200. As you can see from this chart, the market is currently experiencing another spike in volatility and hence it looks like difficult market conditions for 2020.

While spikes in volatility signal difficult conditions for investors, they should ultimately be viewed as an opportunity. As volatility subsides, the market usually sees strong returns. The year immediately post each volatility spike in the chart, all saw positive returns.

In the last week of February, the S&P/ASX 200 lost 9.8%. The Australian market has only seen losses of that magnitude three times since 1980. Once after Lehman Bros collapsed in October 2008 and the other two during the October 1897 stock market crash.

Volatility and individual shares

So, does volatility play a part in the outperformance or the underperformance of stocks?

The more a stock tends to move, the more uncertainty is usually associated with the stock. Large upward swings are often even more quickly replaced with large downward dips.

We know that expected return has a small positive link with expected volatility, but what about actual returns?

Volatility and uncertainty — a vicious circle

There seems to be a relationship between uncertainty and underlying volatility of a stock.

A common misconception is that the riskier and more volatile the stock, the higher the potential performance. But this may not be the case.

David Blitz and Pim Van Vliet in their paper “The Volatility Effect: Lower Risk Without Lower Return” find an interesting phenomenon. They present empirical evidence that lower volatility stocks tend to earn high risk-adjusted returns.

That’s right. Taking big risks might not be worth it!

Blitz & Vliet suggest that investors actually overpay for risky stocks.

Conclusion

Spikes in volatility signal uncertainty in markets and difficult conditions for investors. However, history shows that these volatile conditions can be used by investors to find attractive buying opportunities on the market.

Bouts of high volatility are usually followed by period of low volatility.

Happy Investing!

Julia Lee

Chief Investment Officer
Burman Invest

If you would like us to do the hard work for you, visit www.burmaninvest.com.au/apply

1 thought on “How to use volatility to navigate markets”

  1. That you Julia. I just watched your segment on Ausbiz. A big fan and hope your new venture does well.
    Know doubt we will see more of you on Ausbiz.

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