At my daughter's fourth birthday party last weekend, I took the advice of a playgroup co-ordinator: at that age, everyone has to be a winner. So when we played musical chairs, the child who could not find a chair when the music stopped nevertheless got a little gift; so did the child who found the last remaining chair.
What fascinated me most was that none of the children figured out that the reward for diving towards a chair was pretty similar to the reward for not getting one.
I wondered what long-term hang-ups the seed I planted about achievement and failure will yield one day, and at what age children suss out how to beat the system.
Equities are considered growth assets - that is, they provide capital growth, as well as income. The potential for capital gains is often the primary reason for buying equities. Cash and fixed income investments, by comparison, have a much larger income component, while property, which normally lies somewhere in between equities and cash, provides an element of growth, as well as income.
Over the past few weeks the music has certainly stopped, at least for the moment, for the stock market party. Once again we are reminded that investing in a growth asset is accompanied by volatility, even though a strong uptrending market can trick us into believing that the rules have changed and that everyone can be a winner all the time - much like I did to the children at the party.
Fascinating indicator
Volatility, which literally means instability or unpredictability, is an obsession of many market players, particularly those who deal in options and other derivative instruments.
A closer look at this fascinating indicator shows why.
Historic volatility indicates how volatile or unpredictable the market has been in the past. It can be measured over the shorter term - such as daily, hourly or weekly - or over long-term periods.
Volatility most frequently refers to the standard deviation (a statistical measure or formula) of the change in value of a financial instrument over a particular period of time. It is often used as a measure of how risky the instrument is.
Volatility is typically expressed in annualised terms, and it may be either an absolute number (R5, for example) or a fraction of the initial value (say, five percent). Without going into too much detail, given certain assumptions, the standard deviation means that for about two-thirds of the time, the instrument is going to move in a range that can be determined by the standard deviation.
For instance, if we look at 12-month movements in the JSE over the past 45 years (adding in the dividend yield), we see that, on average, the market moves up by 20 percent a year. However, the standard deviation of the market is 25 percent. This means that more than half the time an investor can expect the market to give a 12-month return of between minus five percent (20 percent minus 25 percent) and 45 percent (20 percent plus 25 percent). So averages are a little like one-size-fits-all T-shirts. They may fit the average person, but "one size" is a misnomer for most of us.
An investment with high historical volatility tends to have the potential for large price movements, and vice versa. Volatility does not imply direction, so buying a highly volatile investment does not mean you are definitely going to make more gains than if you invest in those with a lower volatility.
Implied volatility
Now let's look at implied volatility, sometimes referred to as "vols". Implied volatility is the level of uncertainty that is implied in the prices that option writers want for writing options.
One way of thinking about implied volatility is a short-term insurer writing a policy for an environment that is either safer or less safe. The insurer may charge you less for insurance if you park your car, fitted with satellite tracking, in a locked garage, than if you leave your car, without an alarm system, overnight on the roof of the Cape Town station.
In general, implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common belief that bearish markets are more risky than bullish markets - whether or not that is, in fact, correct.
Implied volatility is not about the size of the price swings, but rather the implied risk associated with the stock market.
There is an index called the VIX, which tracks the vols of options that trade on the Chicago stock exchange. The VIX index provides an excellent indicator of investors' view of risk.
A recent phenomenon in world markets has been that vols have fallen to very low levels. This ties in with the late stage of a bull market, when the conventional wisdom becomes entrenched. Until recently, the conventional wisdom of the current bull market was that the uptrend in equities would continue, that inflation was under control and that the United States would not raise rates again.
Vols and market direction
For contrarians, comparing the movement of the VIX with that of world markets can yield good clues about the future direction of equity markets. The higher VIX rises, the more uncertain and panicky investors are - turning points in the VIX often coincide with turning points in the market. A low VIX, a range of 10 to 20, indicates that traders have become somewhat complacent, or they are more comfortable with the state of the market.
The VIX peaked at 45 in 2002, and its previous peak was in 1998 - both times when the market was near its lows.
As the current bull market became well established and confidence grew, the VIX fell to an astonishing low of 10. The recent market moves have caused the index to spike at 18.
The VIX can be traded, and fund managers who bought it at its previous lows have made a handsome profit. Markets simply reached that too-good-to-be-true stage and implied volatility returned to a more normal level.
The market's movements in recent weeks have merely served to remind us that some level of volatility is normal, complacency is dangerous, consensus is seldom right for long and you'd better have a good long-term plan if you want to invest successfully in growth assets with their associated uncertainty.
Our market is still up over 50 percent on a 12-month basis.
- Anet Ahern is the chief executive of Sanlam Multi-Manager International