One of the most aggravating aspects of mainstream investment theorists is their tendency to conflate “risk” with “volatility”. The essential argument is that the market rises inexorably over time in an almost completely unpredictable way. It is futile to attempt to time the market, but by choosing stocks with relatively low volatility the bumps in the road can be smoothed out. Though seldom fleshed out, proponents of the theory essentially interchange the idea of “risk” and “volatility”. What is probably most deceiving is that there is an element of truth to it. All things being equal, a stock which has been prone to fluctuate a lot in the past is likely to do so in the future. But in a more important sense, low volatility is associated with much greater risk in the market.
While I agree with Robert Prechter that stock markets do not obey physical laws, I do think that a reasonably accurate analogy can be made between volatility and the physical process of energy absorption. When markets are in states of low volatility they can be thought to be accumulating energy. Conversely, when markets are in high volatility states they can be said to be discharging energy. Falling markets typically discharge more energy, since they are accompanied by higher and rising volatility. Rising markets are associated with lower and falling volatility and so it is usually at these times that the market tends to accumulate energy.
Of course these are broad tendencies and there are many individual exceptions, but the underlying principle is crucial. A market which has recently demonstrated less volatility over a given period relative to another period is not less risky. A stock which was once fluctuating widely from one extreme to another but which has recently focused into a tighter band of motion is by no means a “safer” stock than it was before. The reverse is almost invariably the case. If a stock has recently become less volatile it is probably setting up for a large move, and that may well be downward.
Yes it is true some stocks have a tendency to fluctuate more than others (in the parlance of mainstream theorists they are said to have a higher beta) but this is a comparatively unimportant observation. Buying a stock when general volatility is low may be buying right at the apex of an uptrend, when the market often experiences a momentary calm. Simply choosing a stock with a lower beta is not sufficient. This is like jumping off a shorter cliff to reduce injury on the landing. Ideally the investor should avoid cliffs altogether, not resort to choosing shorter cliffs to reduce the length of the hospital stay!
The notion that volatility and risk are synonymous is one of the gravest threats to successful investing. In fact by analyzing price-to-implied volatility ratios one can easily see that low volatility environments tend to leave the market without support and are actually more risky than high volatility environments. In my view the crucial comparisons are not from stock to stock, or even index to index but rather from one time to another. The fact is that in a rising market, by definition, most stocks will be rising. In a falling market most stocks, by definition, will be falling. Itʼs as simple as that.
Time spent comparing volatility and covariance from stock to stock is mostly a waste of time. Even a novice investor knows that a hot internet stock is going to fluctuate more than a venerable blue chip. Getting the right “blend” of betas appropriate to oneʼs “risk tolerance” is not going to help much when the entire market is plummeting. Rather than fussing over betas, the investorʼs time could be put to better use analyzing current price-to-volatility with respect to historic norms.
The model I admit is far from perfect. One of the problems is that prices move in trends which really have no analog to energy absorption and discharge in a fluid environment. The closest I could come to expressing this within the confines of the analogy is to suggest that the markets behave as if they have a skin which effectively “holds” a certain amount of energy. Stocks will continue to absorb the energy until some point at which there is a rupture, and the process reverses. Still, is that it is often hard to know in advance what amount of energy the market will ultimately hold before it discharges.
