What is volatility and what causes it to rise and fall? How volatility itself contributes to more volatility such as in the example of the chaotic UK government bond market where long-term yields have increased by 4% in 2022.
Topics covered include:
- How the role of volatility has changed in financial markets
- What caused UK interest rates to spike and long-term bond investors to lose 50%
- What is liability-driven investment
- What drives increases in volatility and volatility spikes and spillovers are more frequent
- How to earn income from shorting volatility and what are the risks
- What we can learn when financial securities blow up
WisdomTree CBOE S&P500 PutWrite Strategy ETF (PUTW)
Simplify Volatility Premium ETF (SVOL)
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Welcome to Money For the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today’s episode, 405. It’s titled “When Volatility Rises, Financial Things Break.”
What is Volatility and How Is It Measured
Volatility measures how much a security or asset class deviates from its average. That could be the average price, or it could be the average return over time. A stock or an ETF is more volatile if it experiences greater swings in price.
A stock or an ETF or an asset class is more volatile if its daily, monthly, or annual return deviates significantly from its average, it could be a very high return or could be negative return, but it’s a measure of volatility. And in finance, the statistical measure used most frequently to measure volatility is standard deviation.
Standard deviation is the foundation of modern portfolio theory. If you’ve ever had a financial plan, or an asset allocation plan prepared for you by a financial advisor, or even using some type of online planning tool, oftentimes they’ll show what’s known as an efficient frontier. And they’ll show different portfolio mixes that maximize the expected level of return for a given level of volatility, and that volatility used is the standard deviation.
In a recent editorial in the Financial Times, Eric Lonergan, who is a portfolio manager and author, wrote: “The biggest structural change in investor behavior in the last 30 years is the near-universal adoption of volatility as a measure of risk.” When I read that editorial, I was somewhat—well, I was curious about what he meant and started researching more, because I know as I’ve done asset allocation studies over the years, volatility was just what we used.
How Volatility Use Has Changed
And as I did additional research, I found a paper from October 2017, published by Artemis Capital Management. I believe the principal author of the paper is Chris Cole, who is the founder of Artemis, and they’re a firm that specializes in volatility.
The paper said: “What we think we know about volatility is all wrong. Modern Portfolio Theory conceives volatility as an external measure of the intrinsic risk of an asset. This is a highly flawed concept, widely taught in MBA and financial engineering programs.” I certainly learned it in my MBA in undergrad. Those programs, and typically, our understanding of volatility, as they describe, is an exogenous measure of risk. But Cole points out that volatility actually influences risk itself.
The paper continues: “Portfolio theory, including modern portfolio theory, evaluates volatility the same way a sports commentator sees hits, strikeouts or shots on goal—namely, a statistic measuring the past outcome of a game to keep score, but existing externally from the game. The problem is volatility isn’t just keeping score, but it’s massively affecting the outcome of the game itself in real-time.”
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