The Inverse Relationship Between Performance and Volatility

Includes: DIA, QQQ, SPY
by: Brad Hessel

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%).

S&P 500 Daily Volatility, 1950-3Q09
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:
S&P 500 ROI vs. 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.