January 20, 2009

Don't Be Afraid of Volatility

Volatility is a mischievous thing, as a tool it is of indispensable use to risk managers. But in the hands of the inexperienced and the judgmentally biased it is nothing more than an idea that if explained incorrectly may easily misguide someone seeking genuine consultation. The view of the dewy eyed code writer flogging his programming knowledge to anyone in sight all interspersed with “vol” this and “vol” that, it’s enough already.

This is what I think. Many times clients would ask me about volatility. Now I usually had an idea that volatility from their angle wasn’t the measure used to determine the risk of a given asset, it instead was a measure of market unruliness. So my first effort was to nip that one in the bud. I would explain that there are volatility measures for nearly all assets and that by determining relative value between all those assets volatility takes on a meaning specific to all possible asset behavior. “Volatility can rise in a declining market as easily as it can fall” it all depends on what it implies. I bring this up because the news this weekend reaffirmed that the G7 countries are as glib as Secretary Geitner when it comes to giving the markets what they want. And Japan announced they were experiencing a drop in growth equal to 1974. With the Stimulus bill finally getting signed and no one seems to like it, not even the President, can things get worse? Volatility thinks so. But all the markets need is something to give, some sequential set of numbers that break a trend. I’m confident if the Unemployment rate is (+-) 0.2% that would actually be a favorable result!

One should not offer to impress a client with wild guesses of market behavior; it’s rarely appreciated when it’s right and always remembered when it isn’t. Use volatility to suggest a number of scenarios that could be influenced by the cornucopias of external events that are going on in the world right now. And remember the market is currently held hostage to the economic crises, and as I’ve often said, every crisis is a crisis until another crises takes its place. Remember Iraq?

Rule: The more empowered a clients understanding the more manageable his expectations