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Investors Are More Worried About “Volmageddon” Than Nuclear Armageddon

Courtesy of ZeroHedge. View original post here.

While it might be difficult given that the memory of February’s “volocaust” is still fresh in their minds, investors would be better served if they stopped using VIX as a proxy for market risk.

VIX

That’s because, as Wall Street Journal columnist James Mackintosh makes clear in a piece published Monday, geopolitical risks have, over time, proved far more consequential to investment returns. But in the near-term, investors tend to discount them until crisis erupts.

Investors almost entirely ignored what many thought was a rising prospect of nuclear war on the Korean Peninsula last year, and they have also pretty much ignored the welcome prospect in the past week of peace breaking out. Investors realize they have no idea what the chance of war is, and aren’t even any good at assessing whether it has gone up or down.

By contrast, February’s “volmageddon” had a direct impact on stock prices. The Cboe Volatility Index and its equivalents in other markets are treated by many investors, academics and policy makers as a proxy for risk generally.

This is a mistake.

But of course, over the long term, the risk of nuclear armageddon and its impact on financial markets (to say nothing of civilization) is paramount. So the fact that this isn’t factored into risk models is patently ridiculous, Mackintosh suggests.

Looking back over the history of the 20th century, where communist revolutions and world wars led to massive investor losses, the stupidity of markets ignoring geopolitical trends becomes even more apparent, Mackintosh says. After all, if you owned a casino in Cuba just before the revolution, you lost everything.

There’s a reason for this, of course, Mackintosh says. It’s difficult to predict geopolitical developments – who would’ve predicted a year ago that President Trump would be preparing for a peace summit with North Korea leader Kim Jong Un?

Investors who owned Russian stocks in 1917 or Chinese stocks in 1949 lost everything. London Business School market historians Elroy Dimson, Paul Marsh and Mike Staunton calculate that shares in Austria—which lost two wars and an empire—lost money after inflation over 97 years, even when counting dividends. Shareholders in Belgium, Germany, Italy, France and Japan were down in real terms for more than half a century, as were Spanish investors, who endured a destructive civil war and dictatorship.

Yet, can any of this guide your investments? There is good reason to ignore most of the twists and turns of geopolitics: It is just too hard to assess, as Korea shows. Five months ago, North Korea tested a missile capable of hitting U.S. cities, and talk was of a U.S. pre-emptive strike. On Friday, Kim Jong Un became the first North Korean dictator to visit the south, and the two sides agreed they would sign a proper peace treaty by the end of the year. Who knows what will happen next?

But acknowledging that it’s impossible to predict political developments with anything approaching certainty is different from agreeing that “volatility” is the same thing as risk.

As it operates now, the VIX is really only relevant if you’re trading on a short-term horizon. If you have a long-term position – that is years or decades – volatility isn’t a risk, it’s an opportunity.

But sadly, big banks and pension funds somehow don’t recognize this. Instead, their risk models all rely on the VIX or similar gauges of short-term price fluctuations. So when prices fall, instead of buying, these models dictate that the fund or banks sell risky assets like stocks, exacerbating the behavior from which they are trying to insulate themselves.

My big concern is that so many people now equate risk and volatility that it becomes self-fulfilling. Bank regulations have long had volatility embedded in them via measures of value at risk in their trading books. When volatility rises, the value at risk rises, and banks typically respond by selling stocks—helping to push down stock prices.

If this only applied to banks it wouldn’t matter. But the same sort of thinking applies to insurance companies and pension funds, which typically use volatility as part of the assessment of their portfolios. Combined with mark-to-market valuations and Europe’s Solvency II directive they might well be forced into selling stocks in the next bear market, rather than acting as a stabilizing influence by buying on the cheap. If long-term investors join traders in thinking that volatility is a reason to sell, then the next downturn could be nasty indeed.

Also, according to modern portfolio theory, stocks are typically safer than bonds – particularly government bonds. But tell that to holders of Russian debt before the country’s default. Or even to holders of US Treasurys, many of which have seen their value eroded over time thanks to inflation.

Stocks

But at the same time, a bondholder who bought Treasurys in the 1980s and continuously rolled over their positions would’ve made more money than investors who tracked popular equity indexes over the following 25 years.

When the word “risk” is used investors should question what it means, because one person’s risk is another’s opportunity. Consider the risk categories into which financial advisers attempt to lump assets.

A high-risk portfolio has more equities and fewer bonds, while a very-low-risk portfolio might be mainly cash and Treasurys.

Used like this, risk amounts to little more than volatility, as history shows. Sure, stocks can lose a lot of money very quickly—Treasurys have never had anything like the S&P 500’s 20% one-day loss in October 1987—but bonds can be in some ways worse over time. Prof. Dimson points out that after inflation, government bonds have had losses almost as deep as stocks, and losses that lasted much longer.

On the other hand, it is also possible for bonds to do remarkably well for a surprisingly long time. From August 1987, an investor who had bought 30-year Treasurys and rolled over into each new issue would have been ahead of U.S. stocks a quarter of a century later in 2012, including reinvested dividends and coupons. In the U.K., the 30-year is still ahead of the FTSE 100 from 1986’s “Big Bang” liberalization of stock trading. The real risk over these periods was holding cash, supposedly the safest place to be.

The VIX, which measures the expected volatility of the S&P 500 over the next 30 days, shouldn’t be thought of as a gauge of risk, but instead as a useful tool for pricing insurance, its creator, Vanderbilt Finance Professor Bob Whaley said during an interview with Business Insider late last year.

Unfortunately, understanding the index isn’t a prerequisite for trading it. Just ask the day traders who lost millions of dollars when XIV, a short-volatility ETF, blew up overnight.


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