Financial Econometrics and Empirical Market Microstructure

Volatility is not Risk

When asking investors whether they would prefer high or low volatility investments, most opt for low. Few can tolerate the turbulence of volatility. But low volatility only means low visible risk. What if we put it this way: “Would you prefer low volatility with the possibility of large hidden risk? Or high volatility, but at least what you see is what you get?” Despite record low volatility, early 2007 was the most risky time to be invested. And March 2009 presented exceptional opportunity for returns, despite record short term volatility. As Knut Kjaer observes: “The (future) reward for risk may be at the highest when the market sentiment for risk taking is at the lowest.”

The implication is that as volatility declines, our priority should shift to iden­tifying hidden structural risks. And during periods of high volatility, contrarian investors might weigh the pain of P&L fluctuations against the potential for superior long term returns opportunities.

The contrarian view of risk and opportunity is supported by mean reverting market volatility. Periods of low volatility lull short term investors into a false sense of security, as hidden risks build up until emerging as volcanic outbursts of volatility. The exodus of investors as visible risk reaches elevated levels creates opportunities for longer term investors who can stomach the adventure of a rocky ride. Hence, it should not be surprising that equities—as the most volatile asset class—offer the most superior long term returns on a diversified basis (Siegel 2007).

Figure 11 of annualized daily volatility for the DJIA index over the last century illustrates this pattern. As with most major developed markets, volatility mean reverts to a 15-20 % range.