3 Things You Need to Know About Volatility

By | April 24th, 2016|General|

It is important to remember how well-functioning capital markets work and what prices reflect; prices reflect the aggregate expectations of market participants. Risk aversion, investors’ tastes and preferences, and expectations about future profits are among the many inputs that affect expectations. We should expect these inputs to vary day-to-day. Markets adapt to changing expectations and new information. As a result, we expect prices, as well as the level of volatility, to fluctuate. It is interesting to think of the alternative: If prices did not adjust and remained constant, we would be concerned that markets were not functioning properly.

Do returns during January provide information about returns during the remainder of the year? During the month, the S&P 500 Index had a return of −4.96%, the ninth lowest return for the index since 1926. Based on this information, some investors may wonder whether the returns in January have some predictive power for the returns during the remainder of the year. Historically, a negative January was followed by a subsequent 11-month return that was positive 59% of the time, with an average return of 7%, indicating a negative January does not predict poor market returns for the rest of the year. Looking at the five lowest January returns, excluding January 2016, the average return for the remainder of the year was 13.8% and none of these years finished in the lowest 20 years of annual returns for the S&P 500 Index.

While in the midst of a market downturn, we may be inclined to look for some type of signal as to what the recent period means for future returns, or to assume the current period is somehow different from what we have observed historically. Before jumping to conclusions or attempting to make predictions about what the future may hold, analyzing the available data can provide perspective. It is also important to remember that there is ample evidence that suggests prices adjust in such a way that every day there is a positive expected return on our invested capital. While the realized return over any period may be positive or negative, in expectation we believe markets will go up. As investors, we should remain disciplined through all periods in order to capture the expected returns the market offers.