Volatility timing is extremely hard in practice. This simply because volatility can be very volatile.
We have been researching volatility across all asset classes since 2008 and we’ve discovered some interesting relationships. We have learnt that primitive notion that there is a relationship between risk and return is completely false. Taking more risk over the short or long term often doesn’t pay off and the measures used to calculate risks being taken retrospectively don’t take account of the actual risk experienced when short term path of risk is taken into account. These measures often understate risks actually experienced.
Volatility, at its worst, is like having a cardiac arrest. The patient can experience a near death episode and in some cases the patient actually can die. Financial death is common among day traders. It is proven fact that close to 40% lose money every year and over 5 years 95% of day traders wipe themselves out. By wiping themselves out means that if they start with a certain fixed amount of initial capital, day traders end up depleting all or most of it when they trade for about 5 years.
The reasons are many. But the primary reason is that they don’t understand volatility and thus don’t know how to respond to rising risks. Some shut their eyes in the hope of riding through the worst times. Others get margin calls and are forced out. Some try to average in when prices fall, only to discover that the price spiral downwards continues. Of course from time to time they get it right and end up making money. But often these traders don’t pocket their gains. They get wiped out on subsequent positions.
Like water flowing through a river risk can overflow and break the banks. The resulting floods cause much damage. If one is able to stay on dry land one can avoid being drowned. To do so one has to be able to measure the volume of water being added to the river and the speed with which that water is accelerating and rising. It is a multi-dimensional problem. One should be able to view the river up and down its path and the landscape through which the flow is taking place. One has to be able to estimate the depth and obstacles on its way and the channels through which the water can disperse.
The simplest iteration on volatility can lead to much better outcomes. Volatility jumps or volatility trends give good information about the direction of risk. Algoam came up with Volatility Monitor Indices back in 2011. Based on measures of implied and realized volatility these strategies move in and out of the risky assets into cash or bonds
Alan Moreira and Tyler Muir from Yale Univeristy’s School of Management have now confirmed that the best thing to do is to get out of markets when volatility is increasing and go back in only when it has started to decrease. (John Authers FT March 10th, 2016)
Algoam uses risk overlays in all of its investment processes. Time and again we have shown that taking on more risk does not pay in either achieving higher returns or in accomplishing sustainable returns.
Algoam has models to trade and tame volatility itself.
We are working on the next generation of ‘robo-advisors’ which look at the mechanisms for detecting volatility origination and transmission depending on the asset class and particular instruments. Clearly how volatility forms and transmits itself is different for the EURUSD compared with USDBRL or USDINR. It is the environment in which risk start to take shape and the change in that environment that occurs that determines how risks will ultimately dissipate.
Monitoring, measuring, managing is key to investing.