Volatility might be one of the most misunderstood aspects of the financial markets. In general, investors think volatility is a bad thing–at least when it works against them. In actuality, we don’t mind volatility when it is working for us. You never hear anyone say: “That stock I bought has gone up 10% a day for the past month. I’m getting dizzy trying to keep track. I just wish it would slow down.”

Another investor misconception is that volatility equates to risk. While there is often a high correlation between risk and volatility, that is not always the case. A good illustration is shown on the chart below. The gold line is the daily price activity over the past six months of OIH, an oil ETF (exchange-traded fund). The black line is Northeast Investors Trust (NTHEX), a high-yield bond fund.

Notice that the price movement of OIH is much more volatile than NTHEX. Yet over the period shown here, OIH gained more than 15% while NTHEX lost about 4%. Looking at the chart, almost every investor would say that they would rather be invested in OIH during this period than NTHEX. The reality of the situation, however, is that many if not most investors probably could not have endured the emotional turmoil of being invested in OIH during this time.

Consider that at the end of the first month, OIH was up about 10%. But over the following month, OIH gave back that entire gain plus an additional 10%. That is a 20% loss in just over two weeks. As a financial advisor, my experience is that not many clients could withstand that type of market action. They would be calling and canceling their accounts. We could try explaining that we believed oil prices would continue to rise and that when that occurred, OIH would recoup its losses and post good gains. But it would be difficult to convince investors to hold their positions when there remained the possibility of additional losses.

On the other hand, an investor who owned NTHEX during this entire period might not be too worried even after seeing a 4% decline, just because day-to-day price movements are slight. The investment does not have the emotional roller coaster of OIH which can gain or lose 4% in a single day.

Volatility is uncomfortable when its direction is uncertain.

Perhaps the most commonly used tool to measure investment volatility is standard deviation. Standard deviation is a reflection of how much an investment’s price varies from its mean price over a specific period. But as already explained, variance from the mean price is only bad when it is below the mean. Investors have little trouble with volatility above the mean.

A better tool to measure negative volatility is called the Ulcer Index. This indicator was devised by Peter Martin in 1987. It is designed to measure volatility in the downward direction. The name is derived from the idea that it is only this negative volatility that causes investors stress that can lead to ulcers. To learn more about the Ulcer Index including exactly how it is calculated, you can follow this link: http://en.wikipedia.org/wiki/Ulcer_Index

By virtually any measure, this year has been uncomfortable for investors. There are virtually no sectors with any kind of long-term trend. The chart below shows the price action of the Nasdaq over the past six months and its action is similar to the other major indices. So far the Nasdaq is below where it started the year and the past few weeks the index has been unable to mount a sustained advance even though technical indicators like RSI, MACD, and a 50-day moving average are all positive.

 
Although technical indicators might be positive, most fundamental indicators are currently negative. Investors are currently weighed down by factors such as rising inflation, a weak housing market and lagging consumer confidence. It will be hard for investors to feel warm and fuzzy about the markets until after market volatility swings strongly to the positive side.

F.S.