Investors are constantly scouring market data to try to identify patterns or indicators that suggest what stocks might do next. As investors’ data-processing capabilities increase, they are able to run ever more market analyses and, theoretically, capitalize on more investment opportunities.
While this practice may sound somewhat straightforward, it has some fundamental flaws. Not to mention, some investors mistakenly use backward-looking indicators—such as past volatility or the VIX—to try to predict future market volatility or stock price moves. In this article, we will discuss the flaws of technical analysis, the fleeting nature of profitable market indicators and the ways we believe investors should (and should not) use volatility in their portfolio decisions.
Technical analysis uses past asset price trends or patterns to try to identify near-term investing or trading opportunities. The primary issue with most technical indicators is their backward-looking nature. They analyze past data to predict what might happen next for stocks or other assets. While historical analysis can be useful in assigning probabilities of potential outcomes (as we will discuss later), investors must understand that markets are not serially correlated. That means yesterday's stock price or market movements don't predict today's or tomorrow's.
If you think you have found a consistently predictive stock market indicator using technical analysis, be careful! Market data are widely available and modern technology allows most investors to run sophisticated analyses just as easily as you can. Fisher Investments' Executive Chairman and Co-Chief Investment Officer Ken Fisher refers to this phenomenon as ABCD—anybody can do it. Because so many investors scour data to identify potential trading opportunities, we believe any investment edge they offer is fleeting and almost instantly priced into markets.
Many technical indicators rely on stock price movements, and some folks try to use volatility indicators—such as the VIX or other volatility indexes—to predict implied volatility or future stock price movements. However, as we previously mentioned, technical indicators are often backward-looking. For example, volatility is commonly measured by standard deviation—how much returns deviate from their average over some historical period. Low standard deviations mean the results didn’t vary much and high ones mean there was more variability. However, since the standard deviation measurement uses historical data, it can only tell you what has happened in the past—not what will happen in the immediate future. Trying to predict future market movements or volatility levels based on past volatility is like trying to drive while looking only in the rearview mirror!
That said, past volatility and standard deviation can be useful for long-term investors in other ways. While historical volatility is not a forecasting tool, it can be incredibly useful in deciding which assets are best suited to help you toward your investing goals. You can use historical volatility to get a sense for how volatile different assets are over different periods.
For example, let's assume you're trying to decide what mix of asset classes you should have in your portfolio based on your growth needs, volatility tolerance and time horizon. Over five-year rolling periods, stocks have a 10.0% average annualized return with a relatively high average standard deviation of 8.6%.[i] On the other hand, bonds feature a 5.2% average annualized return with a 3.9% average standard deviation—less return potential with less volatility. [ii] However, bonds’ lower-volatility edge evaporates when you zoom out to longer timeframes. Over 30-year rolling periods, stocks return 11.1% annualized on average versus bonds’ 5.6%, and stocks do so with less volatility—an average standard deviation of 1.3% for stocks versus 2.7% for bonds.[iii] For investors with longer time horizons, strong long-term stock market returns may be well worth their higher short-term volatility.
While analyzing past volatility can't tell you exactly what will happen over the next day, month or year, you can use historical data to gauge potential risk and return for different asset allocations. In this way, volatility indicators can be extremely useful to investors looking to identify the optimal investments to help them toward their investing goals.
[i] Source: Global Financial Data, as of 12/31/2020. 5- and 30-year rolling returns from 12/31/1925 - 12/31/2020. Stock return based on the S&P 500 Total Return Index—a capitalization-weighted, unmanaged index that measures 500 widely held US common stocks, representative of the broad US equity market. Bond return based on Global Financial Data’s USA 10-year Government Bond Total Return Index.