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Thursday, 23 February 2017
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Risky Business

 

The US market is hitting all time highs and has blown out of the top of its quite long term trading range. Trump the pump has added 15% to our market and the US market and the common cry is that everything is getting very risky. But what is risk and how do we measure the risk of the US market, our market, or a stock? It a bit 'ethereal'. So here’s a quick explanation of risk, it’s actually quite simple.

MEASURING RISK

In the financial world, the measurement of risk highlights the difference between an investment whose returns fluctuate wildly and one that doesn't. Wombats and Kangaroos may travel and arrive together but one quietly plodded its way there and the other was up and down the whole trip. 



Take two stocks, one a Wombat and one a Kangaroo. Both return an average of say 5% a year - they travel the same distance in the same time and because of that they appear to have done the same thing. But lets say that historically one stock’s annual return deviates from the average by just 2% a year (so it can return 3% to 7% in any given year) and the other one deviates by as much as 10% a year (so it returns anywhere from minus 5% to plus 15%). The first is the Wombat, the second is the Kangaroo.

Clearly, the first one is pretty predictable, boring even, and the second one is volatile, jumping around all over the place. The second stock is more risky and it is clearly useful to know that before you judge the two for their performance between two points and choose to invest in one or the other. On the surface they are the same but if you were riding them both the journeys were very different. 

That’s why, in order to judge the suitability of an investment, you really want someone to tell you how risky or volatile it is, whether its a Wombat or a Kangaroo. To put a number on that will allow you to get a handle on the risk you are taking. So what number do we look for?

STANDARD DEVIATION - THE RAW DATA

In its raw form, there is a measure called standard deviation. No one uses it but it is the foundation of all the other indicators. Standard Deviation (STD or Sigma or σ) measures the ‘volatility of past returns’ and purports to tell you how reliable your future returns are likely to be based on how reliable they have been in the past.

A volatile stock will have a high standard deviation while a stable blue chip stock (is there such a thing?) will have a lower standard deviation. A large STD tells you that the share price is deviating a lot from the average or in the case of stocks, from the moving average. If STD is zero the stock isn’t moving at all.

When you use a moving average as your base line you will begin to realise that it doesn’t matter if a share price trend is up or down (the moving average is rising or falling), the standard deviation or volatility is not related, it can be high or low irrelevant of the price trend – because it is measuring how volatile the returns are not whether the price is going up or down.

So let’s see this in action. Here, for instance, is CBA showing the standard deviation in the bottom chart which you will see is in dollars. (You can pick different variables for calculating STD but this one is using weekly data and volatility is measured over the last 26 weeks).

You can see that the standard deviation (risk) of the CBA was running at about $2 (suggesting it moves up and down $2 a week) from 2011 to 2015. Then you might remember all the banks started going down in early 2015 as they raised capital and there was all that press about a property market collapse. The sector fell 31.4% from Feb 2015 to Feb 2016. During this time the standard deviation jumped from $2 to $6. In other words, they became more risky, bounced around a lot more than usual and there is not a retiree out there who did not feel the pain of that.

But as I say, no-one uses STD in the investment world because quoting a $4.78 STD on CBA doesn’t really tell you anything about how risky it is unless you relate it to the share price and then relate that to other stocks.

So traders, investors, fund managers and particularly technical analysts have developed lots of other measures of STD that are a lot more useful when trying to assess the risk of a stock or investment, measures that allow you to compare the risk of one stock to another.  

The established volatility indicators include:

  • Average True Range.
  • Bollinger Bands.
  • Chaikin Volatility.
  • Twiggs volatility.

AVERAGE TRUE RANGE

A very useful and easy to understand volatility measure is Average True Range – we have written about that below:

You can access ATRs in our All Ords Spreadsheet.

This is our CBA chart over 5 years with the STD and the ATR plotted – the ATR is showing us the average range of price movement each week over the last 14 weeks - you can see again the pick up in volatility during 2015 when everyone was worrying about the banks:

BOLLINGER BANDS

Another volatility based measure is Bollinger Bands. We wrote an article about those recently – click below – these graphically show the risk of a stock by plotting two ‘bands’ around the moving average that are a specified number of 'standard deviations' (average movements) from the moving average.

Here is the CBA chart again showing the Bollinger bands – again there are many variables, this one is based on weekly data and plots the upper Bollinger band (red) two standard deviations above the moving average (grey line) and the lower Bollinger band (blue) two standard deviations below the moving average. The bigger the gap between the two Bollinger bands the higher the current standard deviation. So you can see in 2012 to the end of 2014 the bands were close together then in 2015 they widened significantly, came together again this year and are now widening out again in this Trump inspired rally.

Bollinger bands purport to identify buy and sell signals depending on what the share price is doing within the Bollinger band.

  • Contracting bands warn that the market is about to trend: the bands first converge into a narrow neck, and this is likely to be followed by a sharp price movement.
  • A move that starts at one band normally carries through to the other, in a ranging market.
  • A move outside the band indicates that the trend is strong and likely to continue.
  • A trend that hugs one band signals that the trend is strong and likely to continue.
  • You can look up Bollinger Bands on Investopedia or Incredible Charts.

CHAIKIN VOLATILITY and TWIGGS VOLATILITY I will cover at a later date maybe. Too technical to explain here.

VIX VOLATILITY

The most well-known measure of volatility is perhaps the VIX Index in the US or the “Fear Index” as it has become more glamourously known. The VIX plots the ‘implied volatility’ of S&P 500 index options quoted on the CBOE. To explain that, the VIX is calculated by the Chicago Board Options Exchange, the options market in the US. 

Option prices have for decades been calculated using a formula which includes the standard deviation of the stock. So what they do to find the STD of the index is work the formula backwards, from the price, and derive the standard deviation of the stock or index from there. This is the volatility that is implied by the current option price. Hence the expression ‘implied volatility’. 

The VIX is a plot of how the volatility (standard deviation) of the S&P 500 index is changing each day derived from the price of options over the S&P 500 index each day.

This is the Black-Scholes Formula that is used to calculate the price of an option. I used to have this running on an excel spreadsheet. Almost all the numbers are facts except for the one thing you had to estimate – Sigma, or σ or STD, the standard deviation of the stock or index. The volatility. You can see Sigma (STD) underlined below with “est.” next to it which stands for “estimated”. But if you have the price already (from the options market) you can see that you can work backwards to find the STD implied by the price. And that's the VIX, the implied volatility of the S&P 500 index.

Here is the VIX or “Fear” index chart.

You can see from this VIX chart how volatility or “Fear” exploded in the GFC. You will also see that current volatility or “Complacency” is currently, helped by the Trump rally, as low as it’s been in decades. Everyone is super confident and happy it seems.

But the use of this chart is a bit contrarian. The idea is that you spot when the market is at its extremes of fear and the extremes of happiness and then do the opposite. “Buy when others are fearful and sell when others are greedy” as Buffett says.

At the moment this chart suggests the US market is way too comfortable and we should be looking to sell not buy. It is telling us that a correction is coming.

But before you sell everything you need to understand the weakness in a lot of financial forecasting and in the measure of volatility. Volatility, like many indicators that purport to predict the future, is an observation of history, not the future. Anything could happen in the future and anyway, the money in shares is only ever made when the unexpected happens, because the expected is already in the price. 

The value of the VIX, and there is a VIX for the Australian market as well, is in spotting a change in volatility, spotting that something is changing, something is beginning to happen. That's why, rather than sell everything now, you would wait for a rise in volatility in the US before calling the top. It hasn't happened yet.  

RISK AND REWARD

If you can measure the standard deviation (risk) and compare that to the average return (the reward) and do that for every possible investment in the world and plot them on a chart of expected return compared to standard deviation (risk) then you start to get a picture of what you should and shouldn’t be investing in.

In a perfect world, a world that perfectly matched risk to returns without error there would be a straight line from the bottom left-hand corner of the chart (low-risk low return) to the top right-hand corner (high-risk high return). Bookies are an example of a business that constantly prices risk against reward and makes money from exploiting our ignorance or recklessness towards the relationship.

Investors in theory (easier said than done) can do the same thing, identify risk and reward and exploit the imbalances between price, return and risk.

Cricket is an obvious example as well. How much risk do you take for runs? The Big Bash League, for instance, has offered a product with a much higher risk reward ratio than Test Cricket. Batsmen are forced to take risk because they have so little time and it makes for a very different spectacle altogether. 

Here is a classic Risk Reward chart which includes a couple of cricket shots, Tatts Lotto and my teenagers. 

But, before you go off trying to plot everything with a return against how risky it is, let me just finish the lesson with one final addition to the chart. There is a baseline all financial investments have to compare to. It’s called the risk free rate. It’s a simple thing. It’s the return you can earn without any risk at all. Traditionally in the investment markets, this is represented by the return on Government Bonds. They are not strictly risk-free as I’m sure Greek and Irish bond investors have found out but they will do.

The 10-year bond yield in Australia is currently 2.8%. So theoretically you can draw a straight line across your chart at a return of around 2.8% and any investment whose expected return is less than that but isn’t risk-free can be instantly discarded. Why invest in a risky investment that returns less than a riskless investment. Pointless. So the chart looks like this:

Where this gets interesting of course is when something plots above or below the expected return versus risk line. When the expected return is well above or below what it should be compared to the risk. Opportunities like that would stand out on the chart and be invested in immediately or discarded as stupidity.

So lets look at a few investments before tax, fees, and inflation:

  • The Stock market – Expected return of around 9% (All Ords accumulation index compound return since 1935 – includes dividends). Risk 6 out of 10.
  • Bonds – 10-year return of 2.8%. Risk zero (ish).
  • Paying off the mortgage – Pretax return of 4% (Standard variable rate) which grosses up to 5.7% pretax. Risk zero.
  • Tatts Lotto – Expected return of one million percent. Risk of a 100% loss is 9.99999999999 out of 10.
  • Marriage - Expected average return of one extra income, zero to four kids, two possible inheritances, a free life coach even if you don’t need one, onerous school fees and a dog. Risk = see below. Reward = long term love, fulfilment and satisfaction.
  • Divorce – Expected return of minus 50% (or more). Risks unknown. 

It used to be that with mortgage rates at 7% you would get a risk free return of 10% by paying off your mortgage. It was a no brainer compared to other investments. 

The bottom line is that before you buy a stock you should have some handle on how risky it is. The ATR listings in our All Ords spreadsheet expressed as a percentage of the share price is an obvious measure you can use.

This is a listing from that spreadsheet of the most high-risk and low-risk stocks in the ASX 200 based on their weekly ATR which is shown as a % of the share price.

The least risky stocks in the top 200:

The most risky stocks in the top 200 based on their weekly ATR as a % of price. Lots of volatile gold stocks in here. Stocks that have big momentary share price movements (after a shock drop or jump on a profit warning or a takeover for instance) will 'momentarily' appear in this list then when the shock drop moves out of the 14 day or week period that is used to calculate the ATR the volatility will suddenly drop. So bear that in mind. If the chart has a rift valley look to it, it may not be that volatile, it just had one very volatile day or week in the last 14 days or weeks.   

All these numbers are right there in our All Ords Spreadsheet. For that CLICK HERE.

You will make as much (save more) money by avoiding high-risk stocks as you will identifying and investing in low-risk stocks.

Everything is risk and reward and prices are a combination of both. Looking at one without the other is like investing with one eye shut.


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