The Inverse Relationship Between Performance and Volatility

Volatility in the ebb and flow of the S&P 500’s valuations declined for the third straight quarter in 3Q '09. The average daily change in the value of the S&P 500 index for 3Q '09 was +/-0.8%, down sequentially from +/-1.3% in 2Q '09, +/-2.0% in 1Q '09 and a nightmarish +/-3.3%—the highest level of volatility in a quarter since the inception of the S&P 500 index—in 4Q '08 (as previously discussed in April 2009 and July 2009).

For the entire year 2009, the index is currently at +/-1.3% overall and is still on track to be the second most volatile year on record (2008 set a new record at +/-1.7%). If the calming trend continues through 4Q '09, we may drop below the pre-2008 record +/-1.2% posted in 2002. Still, at this point we remain 118% more volatile than “normal” (namely, the all-time average daily change in the value of the S&P 500 index, which is +/-0.6%).

Why do we care? Well, if you are a short-term trader obviously more volatility is a good thing because the opportunities for you to profit are larger and more frequent. But it turns out that if you are a long-term investor, volatility is bad news. In general, higher volatility is associated with a lower return-on-investment. Indeed, the big peaks in the above chart—when the S&P 500 experienced unprecedented volatility—were all negative ROI years: 1974 -30%, 2002 -23% and 2008 -38%. In fact, not merely negative, but the worst three years in the history of the S&P 500 index.

But wait, there's more. It isn’t just peak volatility that hurts. In general, the higher the volatility, the worse the ROI. Check out this chart measuring performance at various levels of volatility:

To build this chart, we calculated the ROI for the S&P 500 index for each year since 1950 and then sorted those years by the average daily change in the S&P 500 index—up or down. Clearly, if you are a long-term investor seeking a 10% or better annual ROI, you want to root for average daily volatility around +/-0.6% or less. In years when average daily volatility has exceeded +/-0.8%, the S&P 500 has a negative ROI, including those three major meltdown years.

We also did a little vector analysis. Since 1950, there were 28 years in which volatility declined from the prior year, and in 18 of those years (64% of the time), performance improved compared to the prior year. There were 31 years in which volatility increased from the prior year, and in 24 of those (77% of the time) performance was worse than the prior year.

We are not saying that volatility causes market declines; in fact, it presumably works the other way around. But if you are a long term investor and detect a rise in volatility, be prepared for an increased probability of sub-par performance by the stock market.

Disclosure: No position in any S&P index mutual fund or ETF.

Comments

[Common Cents:]

Good article which provides lots of food for thought.

While recent volatility is abnormally high, I think if you put a "regression" line on the S&P volatility chart above it would show volatility increasing over time. i.e if the average is .6% it looks like "normal" was around .4% 50 years ago and "normal" may be more like .8 or higher now. That makes sense to me when you think about all the computing technology, speed, rapid info distribution, etc that exists now.

While your attempt to "correlate" returns and volatility is interesting, I think what the upward trend in volatility really signals is that "buy and hold" is less effective today than in the past and that more active trading is more likely to be successful than in the past.

Oct 14 10:27 PM

[Alan Young:]

Bear markets have bigger down days than bull markets have up days. It's not that complicated; volatility is a symptom, not a cause, of the bear market. So it's kind of silly to blame volatility for poor returns on investments. In a bear market, you don't expect returns, unless you short.

Oct 14 10:37 PM

[Common Cents:]

One other point on the volatility data...I believe this is showing the change between the open and the close of the market. If you were to look at the range from high to low for the day the volatility would be much higher.
It would be higher in all periods but my guess is that taking this view of volatility would show even more volatility in recent years.

Also - ETFs are taking market share from mutual funds. Unlike mutual funds, ETFs trade during the day. Seems to me that can fuel more volatility.

As I said in my earlier comment, increased volatility means "active trading" can be more successful than buy and hold.

Oct 14 11:40 PM

[Brad Hessel:]

Common Cents: your secular-increase-in-vo... theory sounds plausible, but all the votes aren't in yet. The S&P 500 index only dates back to 1957 (tho Yahoo! lists derived results dating back to 1950), so the data set is limited. I am working with DJIA data now, and comparable measures of volatility in the 1930s appear to show levels significantly in excess of 2008. Stay tuned.

Oct 15 09:25 AM

[sasoros:]

Please bear in mind that when markets TREND you get autocorrelation creeping into the data, which results in artificially low volatility readings.

Oct 15 09:44 AM