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Risk measurement? Volatility doesn’t cut it

Stock-Markets / Volatility Jun 23, 2017 - 02:19 PM GMT

By: Submissions


Henrique Schneider writes: Almost every investor and almost every portfolio use volatility as an indication of risk. There’s nothing awfully wrong with that. But some investors and some portfolios reduce risk to volatility. And this is a serious error, since gauging on volatility is myopic, misinformed and revenue-averse. Why?

Today, in the sixth year of the bull market, it seems that volatility is on vacation. The CBOE Volatility Index (VIX), known as Wall Street’s fear gauge, is low. What does that mean? It could mean that we are sailing smoothly through a super-safe period. It can also suggest investors may be growing complacent. Or, it can be that the volatility tracking simply informs us about other things than risk. Let’s take a deeper look into the three problems of using volatility as a measure of risk.

First, volatility is myopic, i.e. it only sees the very short run. This might seem strange, since the VIX relies on a vast amount of forward-looking products, like EFTs and futures. But the index’s business is to transform future in present valuation overly discounting future profits and strongly emphasizing actual feelings, be them of fear or of confidence.

For example, volatility indexes spiked only after the last financial crisis broke out and they remained high for a considerable time after markets entered the newest bull-cycle. The very short run perspective of volatility tracking makes investors not anticipate risk and opportunities and introduces a risk and opportunity lag to their behavior. In short, investors relying on volatility tracking will always be late to the cycle.

Managing risk through gauging on volatility relies on the efficient market hypothesis. It also takes on Hayek’s idea that markets are trading places of information. This leads to the second problem.

Second, volatility is misinformed. Just because the financial market potentially facilitates the exchange of information, it doesn’t mean that the revealed information corresponds to all information (or to the true knowledge of market agents). Furthermore, volatility indexes tend to depict information on what is relatively scarce in their world – and not all information.

For example, if the market has a larger problem, but the problem is not conceptionally depicted in the index, risk amasses untracked by volatility measures. Take liquidity as an example. In today’s VIX, liquidity is scarce. And because it is scarce, it is overrepresented in the index. Every inflow of liquidity is received as a minimization of risk, despite the fact that it might increase risks in other areas of higher magnitude, for example asset-price inflation, lower real interest rates, speculator bubbles. In short: investors relying on volatility are blind to other risk-developments.

This information-selection bias roots in a noble intention: not to lose money. But this is not the guiding intention for anyone operating successfully; thus, the third error.

Third, volatility is profit-averse. Maximizing profit is the main driver of investors in financial markets; minimizing risk, on the other hand, is just a constrain under which some chose to operate. Volatility inverses this relationship by suggesting rules like “buy when the market is at its calmest” and “sell when the market is nervous”. Besides being borderline silly, these rules leave much more important aspects out of the equation: fundamental analysis and the opportunities associated with investments.

On the top of that, the sheer identification of calmness in the markets with the absence of risk and nervousness with the prevalence of risk is, well, risqué. Volatility might be a measure, it might even be a useful one, but it is not a measure of risk.

Henrique Schneider

Chief Economist, sgv, Bern Switzerland

© 2017 Copyright  Henrique Schneider - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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