Investing When Markets are Volatile

There is no doubt that one of the greatest destroyers of long term value to uneducated investors is volatility in the market. Educated investors, however, realise that volatility should be treated as a friend. It is Warren Buffett’s adage that you should be greedy when other investors are fearful and fearful when other investors are greedy. In times when other investors are greedy they look over potential problems, and when they’re fearful ALL that they can see are those potential problems.

You may be asking how you, as an investor, can use volatility as your friend?

There is an index on the JSE called the SAVI (South African Volatility Index) which essentially measures the implied volatility in the market at any given point in time. (As an aside the index is calculated by working out the cost of options on the market. The cheaper the option is, the less volatile the market is assumed to be, and vice versa). When investors are fearful we see the index going up, and when they are complacent it generally goes down.

Over short periods (two months used in the chart below) we can see that the performance of the ALSI (red in the chart below) is inversely related to the level of the SAVI (blue) which is fairly intuitive. This isn’t much use as an investor though, as the market has already fallen as the volatility has risen. It does make a nice chart, but that’s about it!

Far more insightful is to track the market return over a longer period (in this case I’ve used 2 years) AFTER the SAVI has hit a high level (I used 35) and what it has been after it has hit a low level (I used 20). The chart below shows what the investment outcome would have been.

A few things to notice:
• 2 year returns after high volatility have been good
• 2 year returns after low performance have been poor
• The SAVI was only started in February 2007, and therefore doesn’t have a long track record
• The SAVI is only above 35 or below 20 for a small percentage of the time

The third point is important and raises an important caveat to this analysis. In an extended bull market investors could very well see good performance from low volatility levels. Equally, in an extended bear market a starting point of high volatility might not necessarily generate great returns. Nonetheless this could be an interesting tool to investigate to compliment valuation work.

Take care,

Mike Browne
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Thu, 03 Feb 2011

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