When Can Volatility Work in Your Favor? A Deep Dive
Written on
Understanding Volatility in Investment Decisions
In my previous discussion about diversification, I highlighted an interesting point regarding volatility (also known as standard deviation): when you're faced with unfavorable bets, embracing volatility might actually benefit you, albeit at a risk.
> If all your investments have a positive expected payoff, diversification—similar to flipping multiple coins—greatly enhances your chances of achieving a positive result. Conversely, if expected returns are negative, excessive diversification can trap you in a loss. Surprisingly, in scenarios where you're compelled to engage in a game with a negative expected return, volatility becomes preferable. If luck is on your side, it could lead to substantial gains.
I felt compelled to delve deeper into this topic, particularly since my previous analysis presumed that investors are aware of the expected outcomes of their investments. This is often true in casino settings, but it certainly doesn't apply to financial markets.
When purchasing stocks (or stock indices), the aim is to secure a positive expected return. However, uncertainty looms—what direction will the economy take? How will interest rates fluctuate? Is the sector's trajectory favorable or unfavorable? What are competitors doing? Is the stock's valuation justifiable?
Thus, despite historical positive returns or favorable projections from Excel models, the potential for negative future payoffs remains significant.
Understanding Negative Expected Payoffs
This concern becomes more pronounced when valuations are elevated. To illustrate this, consider corporate bonds. These bonds provide a yield (interest rate), for instance, 5%, intended to offset the risks involved in purchasing them. These risks encompass unexpected inflation, rising interest rates (which inversely impact bond prices), and the potential for the issuing company to default.
However, just because a yield is meant to compensate you doesn't guarantee it will. In hindsight, you might discover that a yield of 15% was necessary to adequately cover the risks you faced. Consequently, with a 5% yield, you weren't sufficiently compensated, leading to a scenario with a negative expected payoff. In simpler terms, you may have overpaid (as a higher yield corresponds to a lower price).
Traditionally, when the expected return is positive, long-term holding and minimizing significant losses are key to maximizing compounding benefits. A steep drawdown, such as a 60% loss, would require a subsequent 150% return to recover. Here, time favors you, while volatility acts as an adversary.
Reversal of Fortune: When Expected Returns are Negative
Conversely, when expected returns are negative, time becomes your adversary, while volatility shifts to your advantage. A fitting analogy is found in casinos. Since all casino games carry negative expected returns, the longer you remain, the more likely it is that your cumulative returns will dwindle. In this situation, you want the range of outcomes (represented by the red cone) to be as broad as possible to increase your chances of exiting profitably.
Harnessing Volatility: A Strategic Approach
If you strike it rich at a casino, what should your next move be? The wise choice is to cash out and not look back. Continuing to play often results in losing not just your winnings, but also a substantial portion of your own funds over time.
If you find yourself in a game that seems rigged against you, opt for one characterized by higher volatility—specifically, one with substantial optionality. A high optionality bet allows you to wager a sum for a chance, however slim, at a much larger return on investment. This potential for high payoff is your best shot at offsetting the negative expected outcomes.
While avoiding casinos altogether is an option, our financial lives often present unintentional gambling scenarios that are harder to escape. Overvalued tech stocks, soaring real estate, low-yield bonds, cryptocurrencies, and gold—all these assets come with inflated prices that could lead to negative expected returns. Despite efforts to steer clear of these overvalued investments, they often creep into our portfolios.
If we cannot sidestep investments with negative expected payoffs—due to either fear of missing out (FOMO) or misjudgment—it's vital to adopt a two-pronged strategy:
- If you suspect an asset class may be overvalued but wish to remain invested, seek out higher volatility options within that class. However, it is crucial to ensure that this volatility does not stem from declining quality (i.e., poor fundamentals). High volatility can provide the chance to realize multiple returns on your initial investment, helping you escape negative expected returns.
- Limit your exposure to these high-risk bets to an amount you can afford to lose without jeopardizing your ability to compound returns. Such volatile investments are not suitable for everyone and should not dominate your portfolio. Rather, they should serve as peripheral bets that can significantly enhance returns if successful, while causing only minor setbacks if they fail.
Happy investing!