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Profit from Volatility

Traders are comfortable with volatility, but investors need not lose too much sleep over it in the long run

Market analysts use a lot of jargon. One word that often crops up is “volatility”. We all have an instinctive idea of volatility but the mathematical treatment doesn’t necessarily fit the intuitive understanding.

Prices that change a lot are volatile and stock markets undoubtedly fit the bill. Prices move up and down rapidly and (almost) randomly. Mathematically speaking however, a rise or a fall are treated exactly the same.

The standard measures of volatility are statistical tools like standard deviation and variance. Both of these are calculated taking rises and falls into account with equal weights. These tools measure dispersion around a central price that is, the mean, or arithmetic average. There are other methods of volatility calculation but most also treat rise and fall as equal. Most common risk-related measures such as Sharpe’s Ratio also give equal weightage to up and down moves.

Here’s where the intuitive understanding conflicts with the maths. Say, a market gained 1 per cent a day for 10 days in succession and then lost 1 per cent a day for the next 10 sessions. A trader could exploit such a market, first by going long, and then by going short. Most people would consider such a market trending in nature, rather than volatile.

On the other hand, say a market gained 1 per cent on one session and lost 1 per cent on the next session for a 20-day period. Neither a trader nor an investor would be comfortable in such a market; it’s difficult to make money when trends alternate that fast. This behaviour would be considered extremely volatile. Yet in statistical terms, those two patterns would be rated similarly and these two markets would be reckoned similar in volatility. The statistical description doesn’t capture the practical differences between the two patterns.

Both traders and investors need to gauge volatility and they need to develop a practical understanding of which type of volatility is useful and what is not. Volatility is especially important for traders of course. Most traders are comfortable going either long or short and generally prefer a volatile scenario, though different trading styles will exploit different kinds of volatility in different timeframes.

Most investors are wary of volatile markets. Volatility doesn’t really help an investor who is trying to manage his or her portfolio to earn reasonable long-term returns. Any long-term investor has to accept that the stockmarket will always yield variable returns. The volatility may ease if you extend the timeperiods but there will be some volatility of return even in the very long-term. Even if you don’t like volatility as an investor, it helps to understand the type of volatility you’re dealing with. Is the market choppy? That is, is it up in one period and down in the next? Or is it trending? Are there long upmoves followed by long downmoves?

You also need to know what sort of monthly or annual drawdowns you can expect as well as the long-term returns. You can accept “normal” twitches in the portfolio value. If there is something extremely unusual happening, the so-called “black swan”, you may need to take unusual action to hedge it or exploit it. Any stockmarket investor is betting on a long-term upwards bias to stock prices. If the economy is growing, that bias will remain intact. But there will be months and even years of negative returns and also months and years of highly positive returns.

If the market is choppy, it is ideally suited to long-term systematic investing with the concept of equated instalments – rupee averaging as it’s called. The long-term bias will ensure that. One month you’ll buy at high prices and another month you’ll buy at low prices and it will average out. If it’s a strongly trending market, there may be long periods when you should be looking at staggering the amounts you invest, and periods when you should be cutting down on portfolio exposure or even selling. In a highly trending market, it is devastating for even a very long-term investor to take a large exposure at the peak.

Conversely an investor who takes large exposures at low prices will make excess returns. Let’s take a look at the Sensex’s monthly performance, assuming that most long-term investors will be reviewing their portfolios once a month. What sort of returns can you expect in the long-term? What sort of monthly volatility can you expect and how much of that is “good” volatility, meaning prices move in your favour?

A glance at the chart 1: Sensex monthly closes makes it quite clear that the Indian market has been strongly trending through the past 13 years. Since January 2000, it has seen a series of strong trending moves, either up or down. There has never been an extended period when the market has lacked direction. The bias has also been positive. In the 155 months under consideration, considering only closing prices, the index has moved from 5,200 (Jan 2000) till a low of 2,800 (September 2001) and a high of 20,510 (December 2010). It’s at 18,450 now. The CAGR over 155 months has been 10.2 per cent. Clearly the long-term trend return has been reasonable. The stock market has beaten inflation and most other financial assets over this long period of almost 13 years.

However, the trend has never been smooth. If we map month-on-month returns sequentially across this period (chart 2: Monthly change), the volatility at monthly levels is quite marked. There are have been many months when the Sensex has moved 10 per cent or more in either direction. A couple of times, it has moved more than 20 per cent in a single month.

The frequency distribution of m-o-m changes (chart 3: Frequency distribution of change) clearly shows that it is reasonable to expect a monthly move of anywhere between -8 per cent and +12 per cent. Since the long-term CAGR is 10.2 per cent, you could have an entire year’s returns wiped out or doubled in a single month. That means the monthly volatility matters to you.

Again, broad statistical measures will not make this obvious. The average m-o-m change is +1.1 per cent, but the standard deviation is huge. A standard deviation that takes both negative and positive changes into account over these 155 months is 7.5 per cent. If we look only at positive changes, the average movement in the 86 months when the Sensex rose 6.4 per cent, while the standard deviation for those positive months is 4.6 per cent. This means, in a month when the index gains, investors could expect a return of roughly +2 per cent to 11 per cent.

In the 68 months when the Sensex dropped, the average loss was 5.5 per cent while the standard deviation in the negative months was 4.9 per cent. This means in a month of loss, the investor could expect a return of roughly -0.5 per cent to -10.5 per cent. Given a market with trending characteristics and this level of monthly volatility, what can the investor do? First, keep calm if 10 per cent of your portfolio value is wiped out in a month. This will happen fairly often – expect it to happen once a year at least. Second, consider taking enhanced equity exposure if the previous month has closed with a large loss. Chances are, this will boost your returns considerably in the long run. Third, if your portfolio gains by over 10 per cent a month, don’t get excited. Consider cutting down on equity exposure in the next month or even book some profits.