»The Daily Reckoning by Bill Borner

Is the Market too Volatile?
30 NOVEMBER 2013

- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
One feature of stock markets that everyone agrees on is that markets are volatile. Over the last three years, the returns on the Nifty index have had an annual standard deviation of around 18%. This means that in a given year, there is a wide range of possible moves for the market. For example, the market went up by 24% in 2012. In 2011, the market was down by 28%. There large numbers are common across markets around the world.

Does it make sense that markets should fluctuate so much? Think about what we are buying when we buy a stock. We are buying a share of a company's future earnings. Maybe stock markets are volatile because those earnings are also volatile. However, a closer look indicates that this is not the case. When we consider the average earnings of the companies that make up the Nifty index, the annual changes are small. Usually, these earnings won't fluctuate by more than a few percent per year.

By this measure, the market is too volatile. This is because stock prices fluctuate a lot more than earnings do. If the stock price represents what we are paying for earnings, it doesn't make sense that the stock should be so volatile, when earnings are not. Clearly something else is going on here.

There is another factor that impacts stock prices much more than earnings does. That factor is risk aversion. In fact, most market movements are a result of changes in risk aversion rather than changes in earnings. This is especially the case in the short to medium term. Thus, when we see volatile stock markets, what we are seeing is volatile risk aversion, not volatile earnings of companies.

This is good news for investors. When markets are volatile due to risk aversion, we can take advantage of this by buying stocks when risk aversion is high, and selling them when risk aversion is low. It is the same thing as buying when others are fearful, and selling when others are greedy. It is this fear and greed, or risk aversion that makes some stocks very cheap relative to earnings, and others expensive relative to earnings.

Going back to our original question: is the market too volatile? The answer is yes if we are considering only changes in earnings. Since most market volatility is driven by changes in risk aversion, we can use this to our advantage when making investment decisions.

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