Can Volatility Predict Returns?

2016 07 DFA Issue Brief volatility

In this Issue Brief, Dimensional Fund Advisors examines the relationship between current volatility and subsequent returns. When volatility spikes, remaining disciplined in your investments can be challenging. Pundits are quick to link volatility to any number of impending “crises” and to predict that short term returns will be poor, “Brexit” being a recent example of this.

Does volatility predict lower/higher returns?
The chart below shows that average stock market returns appear similar across various levels of market volatility.

2016 07 07 Exhibit 2

Are market premiums higher after high volatility?

Yes, slightly.

2016 07 07 Exhibit 3

Can we improve investment performance by getting “out” when volatility increases?

A trading strategy that moved to T-bills would have under-performed. In the chart below, see that a strategy that maintained a consistent allocation to equities and fixed income (75% US Equity Market/25% T-bills) would have performed better with similar standard deviation. In the real world, this portfolio would:

(1) Be less exposed to frictions like frequent trading and taxes and

(2) Avoid increased anxiety over when to “get out” and when to “get back in”.

2016 07 07 Exhibit 4

Key points:

  1. Expect volatility when investing in stocks.
  2. Attempts to forecast short-term price movements are unlikely to be successful.
  3. Be sure that your asset allocations match up with your desired risk tolerance and your investment objectives.
  4. Stay disciplined and re-balanced in all market environments.

About Christopher Jones

Christopher Jones is the Founder and President of Sparrow Wealth Management, a fee-only financial planning and investment management firm. Before entering the investment field, Chris was a management consultant for Deloitte Monitor. He graduated summa cum laude from Brigham Young University with a B.S. in Economics and a minor in Business Management.

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