To Find The Best Time To Buy, Turn Volatility On Its Head

To Find The Best Time To Buy, Turn Volatility On Its Head
Stéphane Renevier, CFA

over 1 year ago2 mins

Mentioned in story

If there’s one thing we know about stocks and volatility, it’s this: when stocks are rising, investors become driven by greed and forget all sense of fear, and in that fearlessness, volatility falls to the wayside. When stocks are falling, on the other hand, that fear comes back: and the more stocks fall, the higher the volatility becomes.

The chart offers a historical look at the volatility of the S&P 500 when the index has traded above or below its 10-day, 20-day, 50-day, 100-day, and 200-day moving averages. When the index has traded above its moving averages (blue bars), its volatility tends to be around 15%, about as low as volatility ever gets. But when the index has traded below its moving averages (orange bars), its volatility tends to rise significantly: ranging from about 23% to about 27%.

Understanding this relationship can be helpful, but you should be careful not to equate low volatility with low risk and high returns (or high volatility with high risk and low returns). Volatility can actually be a pretty poor predictor of medium-term risks, after all. As you can see in the chart, volatility is lower when prices are breaking higher. But that’s also when stocks are most vulnerable to a change in sentiment. On the other hand, stocks tend to be most attractive – i.e. poised for their biggest gains – right after investors have given up on them, or “capitulated” and sold, and when volatility is the highest. This is what Warren Buffett means when he tells you to “be greedy when others are fearful and fearful when others are greedy”.

Mind you, it may not yet be time to be greedy: investors haven’t capitulated yet, and so you might want to be cautious about buying the dip. But make no mistake: further price falls and a rise in volatility would make stocks less risky, not more. Of course, it might not feel that way, but Buffett never said investing was easy…

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