Volatilitility, vix, and monster waves
I. Volatility
Securities that fluctuate more present a bigger risk than securities that fluctuate less.
Generally, the security with the lower fluctuation is preferable if the return is the same. The most common measure for the fluctuation of securities is volatility. It is calculated from historical market prices. Other influencing values are not taken into account. A timeframe commonly used to calculate volatility is three years.
The supporters of the Efficient Market Hypothesis argue that the volatility of a security is entirely sufficient to assess its risk: according to the Efficient Market Hypothesis, all available information has flowed into the price formation at all times. An information advantage of individual investors isn’t possible based on this theory.
Nobel price winner Eugene Fama as best-known supporter of the Efficient Market Hypothesis recommends accordingly to invest exclusively in passive investments, while taking into account which volatility these investments show to align the investment with the investor’s preferences.
II. VIX
The best-known volatility index with the acronym VIX is calculated by the Options Exchange in Chicago. The index, also named “fear gauge,” is sometimes used for safeguarding and is a popular investment object for professional investors. The reason, however, probably isn’t as much the safeguarding effects but rather the fact that there is barely any other investment whose price can increase up to 50 % in a day. In very many cases the purchase isn’t so much safeguarding as it is a pure gamble.
The VIX has experienced an unusual development even in a long-time comparison. The index has fallen to new historic lows repeatedly this summer.
Many investors see this as a result of the money glut from the central banks that has led to a massive artificial distortion of all asset prices. As an effect, in risk management, the validity of pure volatility observations declines.
The successful US investor Howard Marks, co-founder of Oaktree, billionaire, and author of books and commentaries worth reading, says, “Valuations are not cheap.” He doesn’t say that as a result all stocks should be sold immediately. But caution is advised. To put it in our words: active safeguarding management. According to Marks, this includes especially the insights of Behavorial Finance. Just watch the highly recommended interview on CNBC on this topic.
Jeffrey Gundlach, whose fund Doubleline Marks participates in, goes even a step further and anticipates that before the end of this year the currently low fluctuations will be replaced by a period of much higher volatility. Who knows if this will or will not happen, but it certainly is a possibility.
III. Monster waves
Black Swans, which Nassim Taleb raised awareness about, exist in the field of seafaring, too: they are knowns as monster waves or rogue waves. Until recently, the frequency and size of monster waves was systematically underestimated. “Monster waves are whoppers that sailors tell at the fireplace,” was assumed incorrectly.
Satellite data and video footage have completely changed the perspective on the circumstances. Today we know that hundreds of total losses of ships can only be explained with monster waves. The design of the ships was changed, shipping routes with an increased number of monster waves were identified, and rules for captains were established for how to behave when encountering a monster wave.
IV. Stock exchange crashes are nothing other than monster waves
The safety measures common in the nautical field today aren’t currently en vogue on the stock exchange. The mainstream believes in the forecasts of the Efficient Market Hypothesis: “No one knows more than the market.” In addition, there’s the claim that active risk avoidance is ultimately impossible anyway.
The mantra in the language of the real estate market goes something like this:
“Buy the market. In the case of the DAX index, that’s the thirty most expensive properties that are most frequently bought and sold.”
I haven’t encountered a real estate investor yet who seriously recommends such an approach. However, the recommendation “just buy the index” is precisely that.
Only few investors realize that the benefits of passive investment, which has been noticeable in the past years, are possibly only another side effect of the money glut brought about by the central banks. As an uncomfortable side effect the unlearning of active investment will come at a particularly high price when the ships’ bands at FED and EZB–for whatever reasons–stop playing what investors like.
Just ask a bond investor what effects it had in 2008 that before the crash most investors simply believed in the ability of the rating agencies to correctly assess risks. Most weren’t interested in the conflicts of interest of the rating agencies in this brutal game–it was ever so convenient–and only few can explain today what exactly the problem was. Human greed played a big role–for the agencies and the investors.
We don’t believe that index providers can put together portfolios (nothing other than an index) that are well suited to obtain capital when the ship’s band plays its last songs.
The supporters of the Efficient Market Hypothesis claim that this time everything is different. Modern technology (robo), superior mathematics, and cost advantages have changed everything and, as a result, it’s best to ignore the weather forecast and focus on receiving the Blue Riband (trophy for the fastest crossing of the Atlantic). What can icebergs possibly do to the world’s best ship? Main thing the investors hold on to the investment long enough, then nothing can happen. You had better not asked what former owners of the now non-existent Nemax50 certificates or stockholders of the Telekom stock recommended by Manfred Krug have to say about this.
My thesis is: Efficient Market Hypothesis, ETFs as universal remedy, and the denial of the price relevance of human psychology will ultimately end like the Titanic: as the topic of a Hollywood flick. As for me, there’s really only the question whether Leonardo di Caprio has to get on it again or whether “pirat” Johnny Depp will challenge him for the lead role. It will definitely be a blockbuster when the audience learns at the movie theater why people haven’t changed when it’s about money, fear, and greed.
V. How does this affect me?
The fact that capital investments in general aren’t cheap means that the pursuit of inexpensive investments by itself doesn’t offer enough protection when you want to receive your capital.
For a supporter of the Efficient Market Hypothesis it’s easy. There’s nothing you can do anyway, and as only sensible investment strategy you’re left with holding on to all capital market investments until you die so that you or your heirs are as likely as possible to get to the proximity of the average rate of return.
If you–like Howard Marks–belong to the supporters of Behavorial Finance, circumstances appear completely different. You have the option to compare risks and opportunities, and the result of these comparisons isn’t always the same–quite different from what the Efficient Market Hypothesis maintains. You rather have the option to conduct active safeguarding management or entrust investors who do this work for you with your capital.
Active safeguarding management is an entrepreneurial task in the area of capital investment. Be careful whom you enlist. With managers who are employees of large corporations you don’t know if they even invest in their own products.
Successful capital investment and supporting unpopular beliefs are oftentimes almost the same. It doesn’t usually line up well with internal corporate opportunities for advancement. But you can rest assured that adjusted behavior affects performance–but unfortunately oftentimes negatively.
VI. Behavior in times of crisis
When selecting funds you should take into consideration another risk aspect besides volatility. How has the respective financial product behaved during a period of crisis? Some of the behavior during bigger turbulences on the market is quite different from what volatility indices would have you expect.
The following graphic shows the volatility of the Mellinckrodt fund compared with the DAX-EFT of iShares and with the stock funds Germany of the DWS. The DWS fund shows the highest returns in a three-year timeframe compared to DAX and Mellinckrodt. Mellinckrodt shows the lowest volatility by far of less than half of the other two.
The second graphic shows how intense the price loss was in the last stress phase. In the timeframe December 2015 to February 2016, the EFT and DWS funds fell four times as much as the Mellinckrodt fund. No problem if you enjoy roller coaster rides. The DWS surely rewarded you with a surplus return of 1.3% in the past three years. The passive product unfortunately failed, and there was no surplus return.
The significantly lower price loss of the Mellinckrodt fund is the result of active safeguarding management that places particular value on keeping losses to a minimum during heavy sea. The price development in 2017 offers more illustrative material.
Active safeguarding management is an important ancillary building block that helps maintain your assets even during heavy sea. A passive head-in-the-sand rarely is a good solution in real life or on the stock market.