Market Volatility Makes Us Nervous

Asset-price declines could prove durable.

Here we go again.

Photographer: Spencer Platt/Getty Images
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Stock market swings do not matter to most investors, precipitous drops in prices are acceptable if they are followed by sharp rises, and this remains true no matter how long the phase of heightened volatility.

If the above is your investing credo, you can ignore another roller-coaster week in markets, in which the major indices fluctuated wildly, including intraday. On Thursday, for example, the Dow closed 227 points higher after falling more than 360 points on Wednesday. And the sessions were wild on both days.

But volatility does matter to investor positioning, risk appetite and the formation of price expectations. And the longer it lasts, and especially if it is the “volatile volatility” of recent weeks, the more likely it is to be accompanied by a durable decline in markets overall.

Consider this thought exercise: You are driving on a road that has an increasing number of potholes, resulting in quite a bumpy ride. Wouldn't you start worrying about the increasing probability of damage to the car, and slow down?

A similar process is likely to unfold in markets. Some of the greater risk aversion occurs automatically, including among traders and investors who pursue approaches that condition portfolio construction on measures of overall market risk based on volatility (such as VAR, or value at risk). Some of the slowdown will be due to unfavorable revisions in the “risk-adjusted returns” that are critical inputs for asset allocation models. In addition, investors, even though they enjoy the up days, are likely to increasingly worry that the downward phase increases the probability of a more damaging air pocket.

The recent volatility also has undermined the conventional wisdom that investors should “buy on dips” -- this week, at least one brokerage house advised clients to “sell the rallies” in this period of heightened market volatility.

Partial indicators suggest that portfolio risk already has been reduced, notably among hedge funds and broker-dealers. There has been some reduction by longer-term institutional and retail investors as well, but it has been limited so far.

This period of heightened volatility is likely to persist given that investors can no longer rely as much on monetary measures to calm the markets, especially now that the systemically important central banks now are pursuing divergent policies. That makes it more likely there will be more durable declines in asset prices as a whole. And, if a comprehensive policy response continues to be delayed, the declines could be quite large given the extent to which market prices have been decoupled from fundamentals.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.