An upsurge in volatility in financial markets can test the nerve of many investors, particularly after a long period of relative calm. The big question is whether periods of volatility say anything about expected returns.
Of course, there are bound to be all manner of post-hoc explanations in the media about what caused this latest bout of volatility in markets and how all of this was totally predictable. (Oddly, these neat explanations tend to appear only after the fact.)
What we can say, however, is that volatility is a normal part of investing and that tidy cause-and-effect narratives don’t really tell us much that is useful about what comes next.
With that in mind, let’s examine whether market volatility says anything about future volatility, as well as whether it reliably predicts subsequent market performance. To do this, we can measure monthly US equity market volatility using the standard deviation of daily US market returns.
As you can see, we find no discernable pattern that suggests stock returns after rocky periods vary in a way that is attributable to the levels of volatility. In other words, high volatility doesn’t predict weak subsequent returns, and market returns have been positive after downturns. That makes sense as stock prices are forward-looking and reflect aggregate expectations from market participants about future economic developments, as well as market conditions.
What we can see from the data, however, is that periods of volatility tend to be associated with future periods of higher volatility.
The lessons from all of this are that, firstly, volatility is a normal part of a well-functioning market, particularly during periods of higher uncertainty. Secondly, volatility predicts volatility, but not returns.
That all adds to the case for investors to exercise discipline within their chosen plans, staying focused on their goals and resisting the urge to shut stable doors after horses have bolted.
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