Volatility (VIX): A Misleading Measure Of Risk

Chris Cole of Artemis Capital has a broader definition of volatility – “(volatility) is the difference in the world as we imagine it to be and the world that actually exists.” Think about his quote carefully before reading on.

In the investment sphere, Cole’s statement can be boiled down to the contrast between the consensus mindset investors hold to explain the current state of economic activity, fundamentals, market valuations and implied risks versus the reality encapsulated by those metrics. While no one can quantify “the reality”, the wider one perceives the difference between implied volatility and reality, the greater the opportunity present in the market.

Since the 2008 crisis, and especially over the last three years, implied volatility has been abnormally low more often than not. In other words, investors believe the risks of a significant downdraft in stock prices is relatively minimal. This by no mean indicates that the actual risks investors face have decreased per se, just that the financial gauges constructed on investor positioning claim that to be the case.

The graph below plots implied volatility via the VIX Volatility Index (INDEXCBOE:VIX) for the S&P 500 Index (INDEXSP:.INX) since 1990.

Source: Michael Lebowitz

Is the only skill in active investing identifying the long term trade now?

“John McEnroe would lose 6-0, 6-0, 6-0 to today’s top ten players,” he said. “Literally, he couldn’t even play this game.” We were watching Djokovic dismantle Monfils at the US Open. “The history of competition is the study of knowledge and skill.” McEnroe’s skills have long since become common knowledge. “For decades, knowledge and skill were highly integrated in our industry. Which was probably correct, because if you had a lot of knowledge, you could use it to make money.” When the industry was smaller, and you heard a little something about what a central bank was going to do, you’d place your bet and cash in. When you gleaned insight into an earnings announcement, or a merger, you killed it. “The trader’s skill in and of itself was built upon the collection of knowledge ahead of others.” The early outsized returns of our industry greats were built upon this simple formula. “The problem is that this skill — the ability to collect information faster than the other guy — no longer has value, it’s no longer a skill.” Tighter regulations and instantaneous information dissemination has made it knowledge. “Like Martina Navratilova establishing the importance of fitness; the skills and habits she developed are now baseline requirements to compete.” While it’s far easier to collect knowledge than acquire skill, it’s often difficult to delineate the two; in others, in ourselves. We’re so consumed by collecting knowledge that we spend too little time honing skill. “Is there a skill to trading for non-computers? For emotional creatures with blood flowing through their veins? Is it even possible to engage in deliberate practice to become a great trader anymore?” he asked, shrugging. Pausing, reflecting. “After analyzing my biggest wins, I’ve discovered they were all great longer-term investment ideas disguised as trades. This is my skill.”
By Eric Peters – founder, CEO and CIO of One River Asset Management