Volatility: Cause or Effect?

While volatility can exacerbate market downtrends, it's hardly to blame for them

by Adam Warner

    Published on Oct 1, 2015 at 9:45 AM

    Volatility: It's not just for us mere mortals.

    "They may have money to lose, but, like any other investor, they hate to lose it ... High-net-worth individuals (HNIs), who continue to have a high degree of exposure to the equity market, are feeling the pinch from the current bout of global market volatility, with both direct equity holdings and indirect holdings through hedge funds, taking a beating."

    Sounds like all of us. Except there's one large difference:

    "What could possibly make things a little worse for HNIs is the fact that many of them tend to invest on credit. According to the Capgemini-RBC Wealth report quoted above, 18% of all HNI assets are financed through credit. And 40% of credit taken is being used for investments, showed the report."

    Well, maybe that's actually not such a large difference. People do still use margin to play the markets when last I checked.

    Let me make one thing clear, though. It's not "volatility," per se, that's rattling everyone here. It's "assets declining." Volatility is not a cause of assets declining in value. Rather, it's a byproduct.

    We're all humans. Well, maybe the machines aren't humans, though somewhere down the line there's a human programming the machine, and feeling the financial impact of the trading and investing decisions from said machine. Unless, of course, "The Matrix" is a true story.

    Setting that possibility aside, we humans hate losses. And we really hate the possibility of open-ended losses. So we take action to mitigate or prevent those losses. That's gibberish for "we sell into weakness." And the worse it looks, the more jittery we get. And so on. The volatility can and does feed upon itself.

    The dynamics are obviously quite different in a rally. As a whole, we don't need to defend much of anything. Emotions are muted and volatility tends to wither.

    The reason why "volatility" tends to take the blame for all this is that we do tend to see some volatile upside days in the midst of overall downtrends. Like ... yesterday. Perhaps it's a shakeout to the shorts; perhaps it's just many waiting for an uptick before they start buying, and then they get worried about being left out of the turn. Who knows? But that tends to dissipate somewhat rapidly.

    But make no mistake, it's the ugliness of the markets that's causing a bit of a freak-out. It causes the volatility, not the other way around.

    Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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