| As I see it, the most overused description for the
volatility of stock prices over the past few months is,
“The market doesn’t like uncertainty.” Don’t
misunderstand—the headline events are noteworthy.
However, contrary to the conventional explanation, I
believe that the reason investors abhor uncertainty is
because it frequently causes them to misconstrue
volatility as risk.
At the broad market level, when external factors
negatively affect the economy and the markets
intensify, investors tend to lower their expectations of
how well the market will perform. And, conversely,
investors will raise their expectations as these
external influences recede. If history serves as any
guide, this approach—higher confidence in low
volatility and lower confidence in higher volatility—is
arguably contrary to what investors should be doing.
So, what should investors do?
Granted, there is no absolute answer. However, I
offer some very interesting research from Tim Hayes
of Ned Davis Research, Inc.1 on capitalization, style
and sector returns under widely differing levels of
market price volatility. His study reveals results that
are counterintuitive to what investors consider
conventional wisdom.
Using daily price fluctuations from the S&P 500®
Index (and its predecessor), Mr. Hayes constructs two
measures of market price volatility. The first is a
rolling one-year average, while the second is a rolling
100-day average. When the 100-day varies little from
the one-year, market volatility is low. Conversely,
during periods of wide variation between the 100-day
and the one-year averages, market volatility is high. In
turn, these metrics produce defined periods over
which to measure market returns.
The indices shown are for illustrative purposes only and are not meant to
depict the performance of any specific investment See below for index
definitions.
As the accompanying chart depicts, periods (see
end note for details) of high market volatility appear to
favor small-cap (Russell 2000® Index) stocks over
large-cap stocks (Russell 1000® Index). Additionally,
low-market volatility appears to favor large cap over
small cap.
Strikingly, the historical trend runs contrary to many
Wall Street firms’ prevailing asset allocation
recommendations in this current period of high-market-volatility. Rather than repositioning portfolio
allocations toward Wall Street’s recommended large-cap
overweight, the savvy investor, comfortable with
the risks of small cap investing*—if history as a
guide—may wish to consider the potential residing in
small-cap stocks.2
To be sure, past performance is no assurance of
future returns as each market environment is different.
Then again, rising volatility is no reason to dismiss
history.
* Stocks of small-sized companies carry special risks,
such as limited product lines, markets and financial
resources and greater market volatility than securities of
larger, more-established companies.
1 “Are Risk and Volatility the Same? Replay—Style and Sector
Performance versus the S&P 500 Volatility,” Chart of the Day,
Ned Davis Research, Inc., February 14, 2006. The style data
referenced is available in verifiable form only from January 31,
1979. All data used by permission.
2 On September 19, 2007, the Russell 2000 Index had one of its
highest one-day percentage increases since 1979.
Please note that the above table references style considerations
since 1/31/1979 and sector data since 1/20/1972, with all data
ending on 6/30/2007. Additionally, the table is a summation of
NDR studies using NDR’s proprietary information on market
volatility measures prior to 9/11/1989. All data used by
permission, ©2007, Ned Davis Research, Inc.
The S&P 500 Stock Index is generally representative of the U.S.
stock market. The Russell 2000 Index is generally representative
of small-cap stocks. The Russell 1000 Index is generally
representative of large-cap stocks. The indexes do not include
any expenses, fees or sales charges, which would lower
performance. The indexes are unmanaged and should not be
considered an investment. It is not possible to invest directly in an
index.
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