Stock Market Returns and Volatility

Is volatility a friend or foe?

December 2021. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Average stock market returns are similar regardless if volatility was high or low
  • However, given skewed returns, it was not attractive investing when volatility was high
  • Unfortunately implementing a strategy to avoid high volatility periods is emotionally challenging

INTRODUCTION

Active fund managers frequently complain about stock market volatility being too low for their taste and articulate a preference for more volatile markets. When stock markets crash, they can keep calm and carry on with their jobs. Retail investors in panic mode should provide plenty of opportunities to generate alpha. 

And indeed, if we analyze the S&P SPIVA data on the underperformance of US domestic fund managers during the global financial crisis (GFC) in 2009, only 41% underperformed their benchmarks, which was the lowest percentage in the last 15 years. Unfortunately, 65% underperformed in 2008, the first year of the GFC, and 57% in 2020, when COVID-19 struck.

It seems that active fund managers are unable to fully exploit crisis times, perhaps as they panic like all other investors. Volatility tends to cluster and perhaps it is wise not to trade much when volatility is high. Perhaps investors should avoid stock market exposure altogether when volatility is high (read Volatility Hedge Funds: The Good, the Bad, and the Ugly). 

In this research note, we will explore the relationship between stock market returns and volatility.

STOCK MARKET RETURNS WHEN VOLATILITY WAS HIGH

We focus on six stocks markets namely the US, Japan, Germany, Hong Kong, UK, and Singapore. The data history varies for each of these and goes back furthest for the US. First, we calculate the volatility of each stock market using an expanding window. For example, in the US we consider all daily returns since 1926 for determining the top quartile volatility in 2021. Next, we separate the daily returns into when volatility was high, which is defined as the top quartile, and when it was average or low.  

We observe that the average daily returns of the six stock markets were positive across the different ti