Stocks

No, Volatility is Not an Asset Class for Individual Investors

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Over the last few years, there has been a lot of talk about the democratization of investing. Commission-free trading and online access have been the major drivers of narrowing the gap between traders on Wall Street and Main Street for sure, but there is another way in which individuals have caught up with institutions: Retail investors now frequently use strategies and techniques that were, until relatively recently, exclusively used by desk traders in dealing rooms. One of those is to treat volatility as an asset class, something which has become a bit of a catchphrase amongst some financial advisors of late. It sounds good, but is it really a good idea for individual investors?

Before going any further, I should probably clarify what I mean by "volatility."

Volatility is when a market flies around, with big swings each day and over periods of time. These days, though, there are instruments available that are priced based primarily on the level of volatility. They go up when the market starts to jump around with significant drops and big swings, so holders of them make money when volatility is high and lose when it is low. That makes them tradeable instruments, like stocks, bonds, commodities, and other asset classes, so, in theory, volatility itself can now be seen as an asset class.

I should also note quickly the difference between investors and traders -- the oversimplified definition here is that investors are in it for the long-term, while traders take advantage of short-term moves.

Why does volatility matter, then? For investors, volatility is usually a bad thing. It means that portfolio values move around rapidly, a much harder situation to manage than a gradual upward slope in value or a slow, steady decline. For traders, though, volatility is an opportunity. When prices are moving quickly, there is greater risk, but also greater reward on trades you get right. Traders have treated volatility as an asset class of sorts for a long time, using options, futures, and other instruments to hedge large positions. Now that there are easily tradeable ETFs that make those things available to individuals, it seems to make sense for them to use them too.

The problem is that volatility instruments were designed for traders and are set up to solve a trading problem, not an investing one. They offer a decent return in extreme circumstances, and they offer no benefit whatsoever to long-term holders. In fact, because the funds that give individual investors access to them are all managed products with associated fees, they are pre-programmed to lose money rather than offer a return over long periods.

Traditional asset classes are the opposite of that. They offer a return over time in some way, shape, or form. Bonds and other fixed income products pay interest, while both stocks and commodities gain, at least in nominal value, within a system where the economy grows with innovation and productivity gains, and where inflation gradually increases prices of raw materials.

That is not to say that volatility products don’t have a place. I have recommended them several times over the years, but they have very specific, short-term utility. In my view, their principle use for individual investors is psychological.

The worst thing you can do as a long-term investor is to give in to pressure applied by short-term volatility and exit long-term positions. Stock in a solid company with good prospects will go down when the market is dropping dramatically, but the price move doesn’t change the fact that it is a solid company with good prospects. Indices may fly around at times, with well-publicized big daily drops but, over long periods, they march inexorably higher.

So, selling into short-term volatility, then facing the problem of when to buy back in, makes no sense, however your stock portfolio is structured.

Still, the pressure to do so is enormous when volatility is rampant, and the most effective way of handling that pressure is just to do something. In that situation, buying a volatility instrument such as a VIX tracking ETF like VXX or a leveraged inverse Index ETF such as SPXS allows you to tell yourself that you saw the drop coming and did something. Your portfolio value may be dropping, but you have something that is making money and you are doing better than the index, so it is easier to just wait out what has always proven to be a temporary thing. In this case, fooling yourself is a good thing.

The point is that this is a short-term trade that investors can make, with a specific, limited purpose. It is okay to borrow the trading strategies and hedging techniques of traders and hedge funds. We all do it all the time, when we analyze charts and set stop loss levels, for example. However, calling those short-term instruments an asset class implies that they should be a permanent part of your portfolio, and that does not take advantage of them in the way they're designed to be used.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

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