Getting A Leg Up On Investment Volatility


You don’t have to be a financial geek (like me) to appreciate risk of investment loss. In my industry, we have dozens of statistics to look backward and forward to assess what our chances are of succeeding or failing with an investment.  We can look at how volatile a stock, ETF or mutual fund has been, we can see what range of returns it has experienced, how it behaves in bear markets, what its current valuation is versus its own history and much more.  But that’s for the geeks to obsess about.


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In this article, I want to focus on one very straightforward measure of volatility.  It simply asks how often in the past has your security lost at least X% of its value in single day or in a month.  It is called Value at Risk (abbreviated as Va R), and here is a definition from Ycharts.com:

Definition

The VaR is short for “Value at Risk.” The VaR measures how much a security can decrease in a given timeframe. For example, let’s say a stock currently has a 5% Daily VaR (All) of 4%. This means that 4% of the time, the stock has fallen 5% or more using all its price history. In other words, this metric measures how many times the stock has fallen 5% or more in one day out of 100. Therefore, a risk manager could assume the equity will fall 5% in one day once every 25 days (100/4).


To show you how this works in practice, I reviewed VaR for the 100 ETFs I track as a way to monitor market segments.  Here are 10 of the higher and 10 lower VaR’s from that list.  I used daily changes over the past 5 years.  In other words, the VaR shown tells you what percent of the time over the past 5 years the ETF has fallen by at least 5% in a day and separately, 5% in a month.

Val ue at risk for selected market segments:

YCharts 2017


Not surprisingly, gold stocks (represented by symbol GDX) have been very volatile.  They are stocks and their business is sensitive to the price of gold.  During the past 5 years, the price of gold has been higher than $1,700 an ounce and lower than $1,100 an ounce, so that’s a pretty wide range.  And VaR tells us that on 7.4% of trading days over the past 5 years, GDX fell by at least 1%.  On 4.3% of those trading days, GDX fell by 5%.  Another way to think of that is that GDX fell by at least 1% on about 1 of every 14 days, and fell by 5% on 1 of every 23 days.  The rest of the high-VaR list should not shock you: Biotech, Energy, Emerging Markets and Social Media stocks are areas that are moved around by traders who seek volatility to achieve their above-average return goals.  SPHB, an ETF that invests in high-beta stocks, is also living up to its name.


According to a study done by Crestmont Research, from 1950-2016, the stock market went up 53.6% of the days, and went down on 46.4% of the time.  That statistic has been pretty consistent over time.  So another piece of the puzzle to understand and use VaR to our advantage is that all the up days for a security or fund are not considered.  VaR is about chance of loss, not volatility when the price is up.  So another way I look at the GDX example is to say that not only did it fall by 5% on 4.3% of days, it probably fell by 5% on about 8-9% of the days it was down.  So a big loss is not so rare.


At the bottom of the table I list several segments that have had very low levels of volatility as measured by VaR.  Most of these are segments of the bond market, and there is also the U.S. Dollar Ind ex and one equity ETF that invests in higher-yield stocks.

Keep in mind that these are all ETFs, and that individual stocks will have VaR that are quite higher than the baskets of securities shown in the table.  That’s why stock investors diversify across several stocks (unless they are gamblers).

That brings us to my last point for now on VaR.  In investing, history is an excellent guide, but we can’t use it blindly.  Bonds have been fairly tame for the past 5 years, but that is because interest rates have been low and either flat or falling.  The stock market has for the most part been on an upward trend as well.  So while I think VaR is an excellent tool, I am making an educated guess that VaR across the board will be significantly higher in the years ahead than it was during the relatively tame period of June 2012-June 2017.  In particular, I think investors will be taken by surprise when they see how often bond marke t asset classes can fall, and fall hard.


I plan to write more on VaR in the months ahead, so stay tuned.  And understand that sometimes when we are looking to gauge an investment’s potential to cost us sleep, a good place to start is to learn how volatile it has been in the past.  Value at Risk helps us to do exactly that.