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Financial Industry Insights from Advisors Asset Management

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Volatility is a Natural Occurrence


There are many words thrown around that are perfect for communicating a broad concept but ambiguous enough to have personalized interpretation. Liquidity is one such word as is shareholder activism; however, after the recent market action, the term volatility will once again be utilized significantly. Volatility of an Impossible Object: Risk, Fear, and Safety in Games of Perception, written by Artemis Capital Management on October 4, 2012, had a great introductory line about risk and perception:

 

“The Global financial markets walk on the razors edge of empiricism and what you see is not what you think, and what you think may very well be impossible anyway.”

 

Volatility in the equity index takes a view of option premiums interpreted as percentage where empirically one would expect 67% of the next year’s range of returns would fall. For example, a VIX (Volatility Index) reading of 20 would mean option premiums are projecting a range of +/- 20% returns in the S&P 500 over the next year. Now, in the period following the Great Recession, interpretation of the number is baffling many considering sentiment numbers from retail and institutional investors is far more sensitive to bad news than sentiment numbers and volatility numbers currently state.

 

In looking at this, one key psychological concept comes to light – negativity bias. Negativity bias states that we have a much higher likelihood of recalling negative events than positive events. As such, it requires many more positive events to offset or balance out negative events. In the majority of research, it appears we need a 5 to 1 positive versus negative to balance out our bias. This alone explains one of the most profound and consistent investment themes about market corrections and recoveries. The Wall of Worry and the immense amount of counterintuitive action that is required to overcome it will be necessary as much in the future as it is currently and in the past.

 

Consider the tandem in volatility of the U.S. Treasury and S&P 500 VIX. This may be more about the impact of large increases of net worth domestically and intermittent flights to safety in the U.S. Treasury market than an overall historical precedent.

 

volatility

 

Volatility is also spread across the globe. The only exception recently is the divergence of the increase in volatility in the Nikkei Index. The sharp divergence coincides perfectly with the advent of Abenomics, which is the term used for the three-pronged effort of unprecedented fiscal stimulus, aggressive easing on a monetary basis and increase Japans global competitiveness. Consider that since Abenomics was announced, the Nikkei Index is up 36.8%, or an annualized equivalent of 30.7%. One should note that this move may also be in the cards for another region of the world. Recently the European Central Bank has been prepping the world for potential quantitative easing and could see similar impacts on their equity markets. It also may finally dent one of the most overcrowded trades out there…a decline in the Euro currency. We have mentioned that this is a significant, positive move for the European Union being more competitive in global exports.

 

world equity volatility

 

The combination of our hard-wired negativity bias, coupled with the percolating concern over market corrections leads to our Wall of Worry. Corrections are healthy for the long-term productivity of the markets, but we must first address our own pre-dispositions.

 

Perhaps our first step in weighing whether or not we are not too heavily influenced by our negative bias comes from The Count of Monte Cristo novel written by Alexandre Dumas, in collaboration with Auguste Maquet, when Edmond says to Mondego: “It was not my sword, Mondego, but your past that disarmed you.”

 

 

Advisors Asset Management, Inc. (AAM) was not involved with the preparation of third party articles linked to on this page and the opinions expressed in those articles are not necessarily those of AAM.

 

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com


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