Thursday, October 20, 2016

Volatility and Uncertainty: An Interesting Correlation

From Barron's Focus on Funds:

Volatility And Risk: Not The Correlation You Think
Given the rollercoaster ride that has been 2016, from Brexit to terrorism and the presidential election, it’s no surprise that investors are feeling defensive, and have been piling into low-volatility funds, that try to shield investors from market swings (even if flows have reversed of late, maybe because of high valuations).

But taking a step back, volatility has been dropping off, which seems strange given all the scary headlines this year. Yet it makes sense when you consider that data shows the world is slowly but steadily recovering, the specter of recession is receding, and emerging markets’ worst days may be over, says Citi’s Mark Schofield.

Yet before you stop worrying, consider this: The problem isn’t more uncertainty, but less, Schofield argues, as investors are less concerned that the status quo and inequality will be challenged:
A perception of higher certainty creates consensus, consensus creates complacency and complacency creates risk, particularly when the consensus view is reflected in congested, consensus market positioning.
Everyone fears black swans, but the scariest possibility is an event we all expected, but just with a different outcome (think back to how certain everyone was before the Brexit vote that the UK would stay in the European Union).  Caught off guard, investors are more likely to overreact.
He concludes:
It is this type of surprise that tends to trigger the risk reversals that lead to the largest and most enduring moves. This, however, is not reflected in volatility in the market sense, but by a greater magnitude of moves around unexpected outcomes. It is reflected in more “spikiness” in markets, in fatter tailed distributions, in greater kurtosis....