November 2011: What Does Volatility Feel Like?

The VIX Index is a widely watched indicator of expectations for equity market volatility, measuring the level of volatility the market anticipates over the next 30 days. Over its full 21-year history since 1990 the VIX Index has closed above a level of 40 (a level indicating extremely high levels of volatility) approximately 3% of the time. Interestingly, over 80% of those occurrences have taken place since 2008, highlighting the abnormally high levels of volatility we have been experiencing in the past three years.

Our Chart of the Month shows the rolling three-year volatility of the S&P/ASX 200 Accumulation Index using daily index returns from the end of 2003 to today. The chart clearly shows that for the period up to 2007 investors had been experiencing an extended period during which volatility averaged in the 10% to 15% per annum range (and had been building investment portfolios accordingly). Since then, the average volatility that equity market investors have endured has been almost twice that level, in the 20% to 25% range, and they have clearly been spooked by the resultant fluctuations in their investment portfolios.

S&P/ASX 200 Accumulation Index, Three-year Rolling Volatility of Daily Returns

December 2003 - November 2011

Source: IRESS

 So, the question is: what does that feel like? Or alternatively, what returns do investors see when volatility levels change?

We can translate the annualised volatility number into an expected range of outcomes over varying time periods, such as daily or weekly. Table 1 shows two levels of annualised volatility, 12.5% and 25%, broadly representing the pre-2008 and post 2008 market environment respectively. The table also shows what range of return outcomes investors would expect two thirds of the time, based on those levels of volatility, and assuming the returns are normally distributed.

For example, if annualised volatility is 12.5%, then investors would expect two thirds of the time that daily returns would fall within +/-0.8%, and that weekly returns would similarly fall within +/-1.6%. However, if volatility increases to 25%, then the potential range of outcomes doubles in size. Understandably, investors have looked to trim their equity holdings or to build up exposures to cash and fixed income to dampen the volatility of their portfolios to more tolerable levels.

2/3 of expected outcomes should fall within:*
Annualised Volatility	Daily Returns	Weekly Returns
12.5%	+/- 0.8%	+/- 1.7%
25%	+/- 1.6%	+/- 3.5%

Source: IRESS
*assuming a normal distribution