Volatile Compound
Earlier this month, a Harvard law professor had the following insight:
This evening’s New York Times was worrisome. An inset box showed that the S&P 500 had fallen 4.25 percent for the day, wiping out roughly a year of investment returns. A few months ago this would have been the top story. Today, however, it did not even make the front page. There were no articles talking about the collapse of the stock market unless you clicked into the “business” section. Investors in the U.S. economy being destroyed isn’t news anymore.
Combine it with this factoid from Harper’s Index (which, by the way, has a full 25-year searchable list available here):
Number of times in 2008 that the S&P 500 closed up or down 5 percent in a single day: 17
Number of times between 1956 and 2007 it did this: 17
This means that the stock market is more volatile than usual. It may seem like a trivial or obvious statement, but it there are some interesting things to know about volatility.
Volatility means how much something (in finance: a price) fluctuates — variance over time. Looking back over time, people often calculate volatility as the standard deviation of the past year of daily returns, or something similar. Reported as a percentage of the mean, it gives us one way of measuring risk.
Another way of measuring risk is by calculating the implied volatility of an option, the details of which I’ll skip for now. In simple terms, this second method of computing risk uses the price of an option and figures out what risk must be present for the price of that option to make sense. By making this same calculation over and over again for the same set of options, you get something to chart… and when you have something to chart, you can buy and sell it.
And so we get the VIX Index, where “VIX” is the ticker symbol for the Chicago Board Options Exchange Volatility Index. From Wikipedia:
The VIX is quoted in terms of percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, on an annualized basis.
You can see a real-time chart of the VIX on Yahoo Finance. If you take a look at that chart, you’ll see that this measure of risk reached its highest point ever — about 80 — in October or November of 2008. What this means is that in late 2008, the market expected that the S&P 500 index (a set of 500 large companies representing a range of industries in the US economy) to move in one direction or another (we know they meant “down”) about 80%/sqrt(12) = 23% over the next 30 day period. Since then the VIX has dropped to around 40, half of where it was, but much higher than in previous years.
All this to say, keep an eye out for more than just the level of the stock market — look at volatility as well. A risky investment is less valuable than a less risky investment, all things equal, even if they both have the same expected return. So, as the panic subsides, and volatility drops, we should begin to see prices rebound.
