Understanding volatility

October 28, 2011, 2:14 pm Julia Lee Yahoo!7

How do you choose stocks to trade in volatile markets?

There’s no doubt that we’re seeing wild swings in the sharemarket, which is to say we’re seeing lots of volatility. In this article, I’ll take you through some studies that show how volatility impact the performance of stocks.

You might be surprised by some of the findings, which really challenge some age-old assumptions. You may even change your trading strategy.

Volatility

Volatility describes how much a stock jumps around on a day to day, minute to minute basis. The more a stock tends to move, the more uncertainty is usually associated with the stock. Large moves upwards are often even more quickly replaced with large moves downwards. (More from Julia Lee: A New Way To Trade International Shares)

So, does volatility play a part in the outperformance or the underperformance of stocks? We know that expected return has a small positive link with expected volatility, but what about actual returns?

Volatility and uncertainty — a vicious circle

There seems to be a relationship between uncertainty and underlying volatility of a stock.

One explanation is the speculative nature of certain stocks. Small cap and mining stocks tend to attract speculators. This leads to exaggerated bouts of optimism and pessimism. So when the market is uncertain, volatility often increases.

Risky stocks versus stable stocks

A common misconception is that the riskier and more volatile the stock, the higher the potential performance. But this may not be the case. (More from Julia Lee: Trading In A Bear Market)

David Blitz and Pim Van Vliet in their paper “The Volatility Effect: Lower Risk Without Lower Return” finds an interesting phenomenon. They present empirical evidence that lower volatility stocks tend to earn high risk-adjusted returns.

That’s right. Taking big risks might not be worth it!

Blitz & Vliet suggest that investors actually overpay for risky stocks. And their findings cannot be explained away by the ‘value effect’ or the ‘size effect’. Let me explain these ‘effects’ in more detail. (More from Julia Lee: Financial Year 2011: The Scorecard)

Value effect

The value effect describes the tendency for low P/E ratio stocks to outperform the market.

There have been a number of studies documenting this effect including studies from McWilliams, Midder and Widmann, Nicholson, Dreman and Basu.

Dreman and Berry in their paper “Overreaction, Underreaction, and the Low P/E ratio effect” talk about the value effect being due to the market’s tendency to overreact to recent information and discount older information.

Size effect (Banz)

The impact that the size of the company has on returns is explained by ‘size effect’. This is where small capitalisation stocks in general tend to outperform larger capitalisation stocks and the market. (More from Julia Lee: Shelter In A Storm)

The size effect was first published by Banz who looked at performance returns from 1926 to 1980. He divided the market into ‘quintiles’, where each quintile holds 20%, or one fifth of companies across the market. He found that the smallest quintile, i.e. those companies with the smallest capitalisation, outperformed larger quintiles and indeed the market as a whole.

However, there is an argument that once you account for commissions, or brokerage, then the size effect advantage disappears.

Beta, VIX and expected returns

Beta, VIX and expected returns. What do all these have to do with real stockmarket returns? (More from Julia Lee: Strategies For A Bear Market)

Volatility measures how much a stock price is likely to change. It’s usually a historical measure. For individual stocks, volatility is measured by beta. Let me explain what beta is:

  • A beta reading of 1 means that the stock tends to move in line with the market.
  • A beta reading less than 1 means that the stock tends to move less than the market.
  • A beat reading greater than 1 means that the stock tends to move more than the market.

The volatility of the market can be measured by a volatility index. In the US, that’s the VIX index. In Australia, there’s the S&P/ASX 200 VIX with code XVI.

Below is a chart over the XVI over the last year. You can see that from August 2011 to October 2011, volatility has been elevated. For example, in the week commencing 17 October, the beta measure is +32.


So if you’re looking at a particular stock make sure you compare the beta of that stock against the market volatility or VIX. If it’s higher than the market, tread carefully.

What kind of trader are you?

While volatility is the lifeblood for a speculator’s trading strategies, what does it mean for longer-term investors?

If you’re in this market for the long-term, you should challenge conventional wisdom which says that high volatility stocks should outperform over time while low volatility stocks would underperform. Actual evidence suggests the opposite.

What I’ve covered here shows you that you can easily fall into a trap of overpaying for risky stocks. So I’d suggest that stocks showing high volatility tend to underperform over time. And low volatility stocks generally tend to outperform over time. Now is as good a time as any to re-think your trading strategy.

Happy trading!

Julia Lee
Equities Analyst

Bell Direct

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