Good days, bad days

Market volatility is a simple fact of life – it is always with us and as a consequence we just have to deal with it. Sell side financial institutions like it because higher volatility prompts corporate and retail investors to look for some form of asset protection, giving them the opportunity to write more tickets. They also like it because it is possible to make very decent returns if you time the entry and exit from your positions correctly. Conversely, retail investors hate it because their portfolio value can whip around without any obvious fundamental explanation.

How the professionals deal with volatility

Equity volatility is conventionally measured using the prices of index options with near-term expiration dates. The global benchmark is the VIX, which measures volatility for the S&P500. It is currently trading at 22, which is slightly above its long-term average of 19.5 based on data back to 1990 (chart above). This is not excessively concerning. Indeed, as I have noted on previous occasions (here, for example) markets have been far too complacent in recent years as central banks have anaesthetised them with their huge asset purchase programmes. Given the exceptional uncertainty surrounding the economic outlook in the Covid era, it is probably a good sign that volatility is perceived to be slightly above average.

Excessive volatility spikes are rare: We have experienced only a couple of major volatility surges in recent years – once in the wake of the Lehman’s episode in 2008 and another in 2020 as the Covid crisis began to unfold. Institutional investors can hedge some of the risk by investing in an Exchange Traded Fund (ETF) which moves inversely with the VIX. Such indices are only suitable for short-term hedging purposes – those who try a buy-and-hold strategy tend to get burned very quickly. This makes them unsuitable for retail investors who seek more durable protection.

Avoiding the downside yields bigger returns than chasing the upside

As it happens, one of the better protection methods is abstinence. To demonstrate the impact of volatility on investor positions I looked at daily equity market data going back to 1990. Starting with the S&P500 I calculated what would happen if investors missed out on the days with the biggest gains and losses and assumed that on those days the portfolio value reverted to the level prevailing in the previous period. Arbitrarily assuming that investors missed out on the 30 biggest single daily gains, a portfolio which tracked the S&P500 since 1990 would be almost 83% below one which included all trading days. By contrast, excluding the 30 biggest daily losses would have resulted in a seven-fold increase in portfolio value. Putting these two factors together by taking out both the top 30 increases and decreases, the index would have ended up almost 22% higher than one based on the S&P500 alone (chart below). The results are broadly similar for the FTSE100: excluding the largest 30 daily gains and losses resulted in a gain of almost 14% versus one based purely on the benchmark.

In theory we can extend our analysis for the S&P500 back to 1928 without materially changing the results although the volatility in the index during the 1930s means that more than half the biggest daily swings occur before 1940. Arguably the macro environment today is very different to that in the 1930s with economic policy much more sensitive to market volatility. Accordingly it seems reasonable to exclude the 1930s from the calculations. Running the calculations since 1940, and maintaining our exclusion threshold to encompass the top 30 gains would lead to an 85% loss but excluding the top 30 losses would increase the value of our portfolio ten-fold. Excluding both the highs and lows would increase our portfolio value by almost 60% compared to the benchmark over the last 81 years.

If you don’t have perfect foresight, hedge

This demonstrates two key takeaways: (i) big movements in indices have a disproportionately big impact on future gains, perhaps because they trigger sentiment shifts which generate a change in market direction and (ii) avoiding the worst excesses of decline have a bigger impact on portfolio returns than chasing the big gains. Obviously the foresight to know when we are about to experience a massive correction is not gifted to most of us, therefore the best we can do is to hold a balanced portfolio comprised of assets whose prices are either inversely correlated with equities or not correlated at all. As I noted last summer, the 60:40 portfolio strategy which comprises 60% equities and 40% bonds is as good a way as any to hedge risks.

The upshot of all this is that investors who pursue a minimax strategy (minimising maximum losses) are likely to outperform those who follow a maximax strategy (the aggressive maximisation of gains). Indeed the latter is viewed by many in the media as the way in which sell-side investment operates and some hedge funds still publicly hail such an approach as the ideal investment strategy. But a maximax strategy is like building a football team comprising only strikers. Whilst strikers score the goals and grab the glory, the team is unlikely to win anything unless the defence is strong enough to repel the opposition. In football terms a minimax strategy allows the team to build a stronger defence which will allow them to be more successful over the longer term. When it comes to portfolio investment we cannot eliminate our exposure to volatility but we can take steps to reduce our exposure to it. As in other areas of life, buying some protection can considerably reduce our long-term costs.