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Investors get nervous when market volatility picks up and prices move down. Perhaps they should calm down and take action instead.
I understand that price volatility is upsetting. Volatility frequently comes tethered with lower investment value. No one likes to see the value of his portfolio drop.
But investors need to understand that market volatility is not the same as risk, or the probability of permanent loss of capital. That volatility should be confused with risk is understandable. In financial theory, volatility is frequently reduced to a leading number that analysts can point to. Beta, for example, is a measure of a security’s volatility against a market benchmark, usually the S&P 500.
This isn’t to say that market volatility and risk are completely detached. Many sound investments suffered punishing losses in the 2008-2009 sell-off. To be sure, most of these investments returned with a vengeance, but if you were in retirement mode and depended on income (many companies reduced dividends then, even if only temporary) or asset sales, you would have suffered a permanent loss of capital.
With that said, price volatility tends to be a short-term phenomenon, and frequently leads to buying opportunities. Spikes in volatility coincide with hard sell-offs. The following charts reveal that an upward spike in the most-watched volatility measure, the VOLATILITY S&P 500, or VIX, nearly always correlates with a sell-off in the S&P 500. Low volatility, in turn, nearly always correlates with a rising S&P 500.
If we take a more granular view, we see this relationship has held in 2014. It’s no coincidence that the recent sell-off was marked by high volatility.
As these charts indicate, the most extreme cases of market volatility occur during the deepest declines. The decline coincides with the highest immediate fear, the lowest immediate return expectations… and the best opportunity for subsequent high returns.
Of course, enduring short-price volatility is easier said than done, because very deep price discounts can occur. In the 2008-2009 recession, even the bluest of blue chips weren’t immune to the hard sell: We saw stocks like Pfizer (NYSE: PFE), DuPont (NYSE: DD), and Ford (NYSE: F) suffer steep price declines, though all recovered.
Stock prices ebb and flow, as do market liquidity and investor confidence. But it’s a universal truth that long-term investments are better made in deeply depressed markets than in euphoric markets.
The key to exploiting volatility (depressed markets), then, is to keep your eye on the distant horizon. You know that over 1,000 miles a monarch butterfly will make its way to Mexico, so you’d bet on that journey. To bet where that same butterfly will travel over a mile is financial suicide.
Short-term price movement is unknowable, and really unworthy of analysis.
While these are unsettling times to invest, due to the macroeconomic and political factors that receive so much attention, these are also great times for those who have both capital and time who have the ability to focus on the horizon. After all, volatility has picked up, but so, too, have the value propositions.
How to Make 13% a Month Trading Volatility
Andy Crowder recently held a webinar about the “New Bull Market” in volatility and the options strategies he is using to take advantage of it. If you are interested in learning his approach and how to master the art of probabilities please click here.