Topics: Uncertainty, risk, volatility

Oh, hey there… new logo who dis?

Clark Kent becomes Superman when he takes his glasses off.

I become The Stonk Scientist when I put my (blue light) glasses on.

Anyways… haha…

Markets have been muy loco - the Fed raising rates on Wednesday throws in another interesting element. Instead of commenting on all the things, I want to pop in real quick and talk about what’s been driving the market: risk.

“Wow Drake, you’re so perceptive…”

Okay… I’m not done. Give me a sec here.

We… let me speak for myself here… I often characterize risk as how much my portfolio goes up and down in a given week. This, I would argue, is an incomplete view of risk, as there are many different types of risk (and many nuances with each form of risk).

There are several key risks and measurements that most investors are familiar with that I’d like to describe to provide some clarity and perspective: uncertainty, volatility, Beta, and the VIX.

Uncertainty

“True uncertainty is found in the intentions of others” - Peter Bernstein.

In his book, Against the Gods, Peter Bernstein describes the history of probability and statistics and how this field has developed throughout the years. When reading through his book, which was candidly a blur of formulas, methods, and calculations, this one quote stuck out to me; over the last 3 years, there are seldom weeks where I don’t reflect on it. I found it ironic that in an entire book on math, he says that true uncertainty is based on human behavior. Fascinating…

Want proof that it’s true? Look at markets, Twitter, Wall Street Bets, and even the Federal Reserve itself; everyone is trying to guess what the Fed’s future interest policy is, whether more banks are going to collapse, and if we are headed towards a recession - that’s why we’ve seen such wild volatility in equity (XLF is down 12% in March) and fixed income (high-yield option-adjusted spreads have increased 100 bps) markets lately (oh wait, sorry, did someone just ask why I didn’t include Bitcoin?).

Jerome Powell said it best on Wednesday… “We simply don’t know.”

Want proof that people don’t know what the Fed is going to do? Check out the CME’s FedWatch Tool. It’s a summary of what the market expects the federal funds rate to be (via Fed Futures prices). As you can see, their forecast has changed quite drastically; the chart just looks like vomit, but it’s indicative of how quickly and significantly the market is changing its assumptions. Here’s another good Fed Funds probability tracker BTW.

*In April 2022, the market was most strongly expecting the Fed Funds rate to be 250-275 bps (30% probability). That just increased to 475-500 bps Wednesday*

If you think that the sophisticated models of institutional traders give them a leg up in terms of predicting the future of the economy, I’d kindly disagree and encourage you to look at how previous forecasts have panned out (charts below are from the Fed’s Summary of Economic Projects using median results - I’ve aggregated them for you - you’re welcome 🙂).

Go back and watch how Jerome Powell describes the Fed’s financial models; he says “we take fiscal policy as it comes to our front door, stick it in our model, along with a million other things.” Frankly, he’s forecasting more than a million things, he’s forecasting 336 million things. What makes the economy crazy is that the decisions, habits, and choices of a single individual trickle through the entire economy; we’ve very recently seen how influential people can be in an economy (re: SVB). Though there is a plethora of research on economic trends, consumer behavior, and forecasting, there is so much uncertainty in predicting the actions of hundreds of individuals.

It’s my opinion that we’re not playing a game of sophistication, we’re playing a game of risk from uncertainty. Please note that I do see value in creating, assessing, and evaluating financial forecasts, as well as performing economic and financial analysis - it’s when they become our all-in-all or north star that we are led astray.

To get practical, each of us has to accept the degree to which we are comfortable accepting uncertainty. Predicting the future is far more difficult (perhaps just a charade?) than most make it out to be. Less uncertainty in your investments can reduce worry and anxiety, though more uncertainty can bring about higher returns over the long run (via higher discount rates through higher required rates of return)

For my finance nerds out there, here’s the conclusion of an academic study I found fascinating:

How did the researchers define risk, you may ask? As return volatility.

Volatility

“Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security. Volatility is often measured from either the standard deviation or variance between returns from that same security or market index.” Thank you, Investopedia!

In Englais, volatility is how aggressively up and down your portfolio goes. Plz see below:

This would be an example of a lot of volatility (if that wasn’t already obvious haha).

What makes uncertainty different than all of our other measurements of risk is that you can’t measure it using historical price information, whereas volatility (and Beta and the VIX) uses historical market data to quantify the degree of “risk” that we are experiencing in the market.

Frankly, I don’t frequently think about the volatility of market prices a whole lot, as I find it makes me more susceptible to succumbing to fear or greed. In the short term, price volatility tells me that people either (i) are emotionally driven (behavior), (ii) are frequently receiving material company information (transient), or (iii) believe that the company has volatile cash flows (unsystematic risk) (yes, I’m looking at you, consumer discretionaries).

A Forbes article described volatility as “the price you pay when investing in assets that give you the best chance of reaching long-term goals.” Interesting… though we didn’t talk about it today, not meeting your financial goals is another prevalent risk (see here for more).

While volatility is frequently observed in markets (that feeling when you want to throw up in a garbage can because you’ve lost 50% in several months), a more commonly utilized risk measurement is Beta.

Beta

Beta is the volatility of a certain asset relative to another (typically an index). For example, if the price movements of NFLX are 50% larger than those of the S&P 500, the beta would be 1.5. Yay, basic math!

To actually compute it, you gotta take the covariance of the asset’s returns relative to the market divided by the variance of the market’s returns. Thankfully, market data providers, like Koyfin, will typically provide them for you (this is unpaid advertising for Koyfin, it’s just kind of what’s up in terms of financial market resources that are free).

Beta calculates the degree of systematic risk a stonk has relative to the market; this, of course, uses historical pricing data to quantify systematic risk. Personally, I view the degree of operating and financial leverage as a more comprehensive framework for assessing a company’s systematic risk, as the bottom line of companies with more leverage will be more impacted by changes to their revenue (for more, check out DuPont analysis). Also, given the ability of Beta to measure an asset’s exposure to systematic risk, it is commonly used as a component in various valuation techniques (specifically in the creation of discount rates for DCFs).

To diversify your portfolio, you could get assets that are uncorrelated to the market (Beta = 0), though unsystematic risks could still be present if you’re holding a concentrated group of stonks. To hedge your portfolio, go with an asset with a beta less than 0, so decreases in the market will increase the value of the asset; the VIX would be a good example of this.

The VIX

The VIX (Volatility Index), aka the Fear Gauge, is soooo interesting! Most people use it to measure the degree of risk in the market, but it’s much more technical and sophisticated than that (I feel like I’m trying to defend a friend here or something lol). Before we get into it, the VIX is mean reverting to 20, so over the mid-to-long term the VIX will revert back to ~20; this makes for some fascinating trading opportunities. Anyways, here’s a pretty chart of the VIX over time:

The VIX measures the implied volatility of out-of-the-money call and put options on the S&P 500 (SPX) centered around an at-the-money strike price with an expiration date close to 30 days (23-37 days).

Implied volatility, contrary to the historical volatility measurement described earlier, is based on what the market is implying future volatility of the stonk is based on the option’s valuation. Implied volatility should be thought of as a valuation metric, as increased levels of implied volatility will directly result in higher option prices. Thus, when uncertainty and widespread chaos strike, the implied volatility (or valuation) on options spikes because they become more valuable (without accounting for their intrinsic value). Referring back to the previous chart, periods of significant economic fear (2000 tech bubble, Great Recession, and COVID) resulted in widespread market selling and significant increases in the VIX; hence why the VIX is dubbed the fear gauge.

Something to note about the VIX is that, because it only evaluates short-duration options, it is relatively short-term in nature and does not evaluate long-term changes to investors’ sentiment. It is also, in my opinion, more influenced by institutional investors and day traders, as most long-term investors have (or should have) a long time horizon (hence the term “long-term”).

I don’t advocate for using technicals or charts to trade assets, but the VIX is my one exception simply because it’s stationary at ~20. When the VIX is overbought or oversold, it often creates very noticeable opportunities; in the same way you buy undervalued stonks and sell overvalued ones, I buy underpriced volatility and sell overpriced volatility. This works because individuals and institutions seek to mitigate “risk” and are willing to overpay for it during periods of extreme fear - I have an aggressively large risk tolerance, so I am comfortable accepting selling them volatility. This most frequently looks like selling VIX call options or buying puts. For more on this, check out this article. For more on the only technicals I consider using, check out MACD and RSI.

Volatility of Volatility

I got to thinking a few weeks ago about how volatile the VIX has been and I thought to myself, “what if there was a measurement that computed the volatility of volatility??” Lo-and-behold, the market had already created it: the VVIX.

The VVIX represents the 30-day forward implied volatility of the VIX by applying the same calculation that is used to compute the VIX. So, instead of measuring how expensive S&P 500 options are (like the VIX), the VVIX measures how expensive VIX options are.

A relatively high VVIX suggests that the VIX is likely to be more volatile in the future, which can subsequently indicate that the S&P 500 might be more volatile as well. Put differently, if the VVIX is high, it means that VIX options are expensive because the market is expected the future volatility of the VIX to increase; more future volatility in the VIX likely indicates that uncertainty within the market is increasing (but is probably gonna be bad).

Unless you’re trading options on the VIX, the insights the VVIX can provide are marginal, but check this article out if you’re interested in learning more (hint: this chart below would probably come in handy if you do pursue it hehe).

Honorary Mentions:

• The Bitcoin Volatility Index

• Value at Risk

• Your classic fixed income risks: interest rate (market) risk, reinvestment risk, credit risk.

• Liquidity risk

• Risk of not meeting your goals (uninvestment risk)

Conclusion:

• The term “risk” is used extensively throughout financial news headlines, but they often allude to several different types of risk or risk indicators.

• Uncertainty is largely unquantifiable (unless you’d like to take the VVIX approach we discussed) and predicting the future is next to impossible, so it’s important to determine how much uncertainty you can handle when it comes to your financial picture.

• Volatility is the ups and downs of the little line on the stonk chart.

• Beta is the ups and downs of the little line on the stonk chart relative to the ups and downs of a little line for an ETF chart.

• The VIX is really cool and calculates the implied (expected) volatility of the S&P 500 by using market data from options on the index. It’s a gauge to see how much people are willing to pay for options on the VIX.

• There are lots of risks… The more risks you take on, the more volatility and uncertainty you face - but with more risk comes more return (S/O to the Sharpe Ratio - pronounced “shar”-”pay”)

Thanks for reading team!