The pain of volatility

September 10, 2015

The Chicago Board of Trade Volatility Index (the “VIX”) is a fabled measure of volatility in the US Equity Market. It is a measure of the implied volatility for options on the S&P 500 Index and has been labelled the “fear index”. It gives a measure of the market’s expectation for volatility in the US index over the next 30 days.

  • It tends to spike higher at times of “fear” – it hit 80 in the eye of the credit crisis in November 2008 and 48 in mid-2011 during the height of the Euro-crisis.
  • It tends to plummet at times of great confidence or “euphoria” – it was at 10 during the heady days of the 2005/6 boom period and was between 10 and the low teens from mid-2014 to mid-2015.

Since 1990, the median level for the index has been 18.

The VIX rises sharply when markets fall sharply and vice versa. It is, indeed, a great measure of fear and anxiety.

In the six trading days from the 14th of August to the 24th, the VIX Index jumped from 13 (“high confidence”) to 41 (“fear”). The S&P 500 fell 10% in the corresponding period, the UK Index fell 10% and non–US Developed Markets fell 13%. On the 24th of August, non-US Developed Markets fell 5% and the US Market fell 4%. It was hard to endure.

So, what does it all mean?

Well, a solid and central assumption in Modern Portfolio Theory (the body of knowledge that underpins all those “globally balanced diversified portfolios”) is that risk preference is stable; your attitude to risk is unaffected by periods of extreme market volatility.

Now, intuitively, many of us know that such an assumption is simply absurd based on our own responses to periods of high volatility (some of us take more risk, some of us clench our teeth and hang on, while some of us panic and sell).  It takes a strong will to endure volatility.

Finally, a fascinating paper by some Cambridge University academics has shown that risk preference is actually not stable in the face of volatility and that volatility/fear and pain have a substantial impact on the way we think, respond and behave.

The paper, “Cortisol Shifts Financial Risk Preferences”, by N. Kandasamy et al.” shows that:

  • Traders experience a marked increase in the stress hormone cortisol when uncertainty increases, measured by market volatility.
  • In a “double-blind, placebo controlled, cross-over test” they demonstrate that changes in cortisol levels are associated with changes in risk preference. Higher cortisol levels are associated with a lower risk appetite and vice-versa.
  • The effect is greater in men than it is in women (women handle stress more effectively).
  • They conclude “the stress response calibrates risk taking to our circumstances, reducing it in times of prolonged uncertainty, such as a financial crisis. Physiology-induced shifts in risk preferences may thus be an underappreciated cause of market instability

In layman’s terms, we become fearful and risk averse when volatility/uncertainty increases and become positive and risk seeking when volatility/uncertainty falls.

Our investment process, incorporating various measures of market momentum within a rules-based framework is evidently a good way to endure volatility and at the same time identify structural shifts in risk preference that associate with severe market drawdowns. An evidence-based, rules-driven investment approach fits with the way our minds respond to stress.