Panic at the disco…continued

I’m hearing several comments along the lines of ‘oh my gosh, the markets are so volatile!’

Ride 'em cowboy...  Source: Google Finance

Ride ’em cowboy… Source: Google Finance

Yes, these 1%+ daily moves seem pretty crazy.  I mean, how normal is that??  Two approaches, to my mind:

  1. Stats time: the long term (since 1950) annualised volatility of S&P500 returns is around 15.6% (data source: Quandl).  Assuming 260 trading days/year, and roughly normal distribution of daily returns, a 1% daily move is just outside 1 standard deviation.  That infers around a 30% probability of any given day being + or – 1%.  Yesterday’s 2% move?  That’s getting into the tails of the distribution: on any given day, there’s around a 5% chance of a + or – 2% move.  If we further assume daily independence of returns (a very dubious assumption, but one frequently made), the chance of the past 2 days occurring in sequence (1.8% move followed by 2%) is around (5%)^2, or about 0.25%.  That means we should expect this event roughly once a year.  Again, note the dubious assumptions.
  2. Picture time: though the long term volatility in the S&P is around 15.6%, a shorter-term measure of volatility (30 days, exponentially-weighted) shows market behaviour has been decidedly less volatile in recent years.  A previous post remarked on this using drawdowns.  Note that, even with the recent pickup in extreme movements, we’re still a long way from the high-vol days of previous decades.  In fact, our current volatility is about average – 15.9%.
    So this is what volatility feels like?  Source: Quandl.

    So this is what volatility feels like? Source: Quandl.

    Note for those paying close attention to my previous posts, and thinking portfolio management-wise: equities are notorious for a ‘double-whammy’ – higher volatility when returns are particularly negative.  It’s as if long-only investors double down as markets fall.  What to do?  Well, just keep in mind that $100 invested in equities today may perform like $200 if markets really sell off – either buckle up, move to cash, or get diversified.

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