How Volatility relates to the Financial Markets and Life
One discovery recently is this podcast that spun out of Real Vision, a paid online TV program that brings across some of the brightest minds in finance.
Titled Adventures in Finance, they tried to explain and deconstruct one popular or less discussed phenomenon, financial concepts to listener.
This week’s episode is titled Volatility in a Peaceful World and you can listen to it here.
There are some very profound things shared in the episode.
The link between liquidity and volatility. Stephen Diggle is a Singapore based hedge fund manager who made billions on the volatility trade in 2007 and 2008. He explained that the concept of volatility is simpler to understand then most people think and not always involving complex mathematical formulas that most of us won’t understand.
My takeaway is that while I know that risk and volatility are different things, which might not occur to many people, volatility is very much linked to liquidity in essence.
During times of uncertainty, entities are more careful with who they lend money to, and therefore a shrink in liquidity. This creates more panic in the system because we are not sure whether those who need more money, are going to get the money that they want.
The price bid and ask spreads get wider and the prices fluctuate more wildly, most often to the downside in this instance.
In recent times, volatility is extremely low and that is because entities that are not part of the regulation picture of this system is suddenly in the system. We are talking about the governments and the central banks. A large part of what saved us was the injection of liquidity so that the system that was stalling can be “smoothed”
Mr Diggle have stopped looking into the volatility trade. I would have thought that this is the right time to do this. To him, the participation of the central banks and government have made the system rigged.
Margin of Safety and Volatility. If we think about our game plan, we want to purchase financial assets with good margin of safety so that we can get an investment that is closer to a fixed deposit then a gambling ticket.
When we write or sell options, we earn a fatter premium usually when volatility is highest and wait for the volatility to crash downwards then we buy them back.
To have margin of safety in stock investment, we want a situation where we buy when there is volatility, where the earnings/free cashflow/dividend yield is higher than historical so that we get a good cash flow for waiting for the price to come back. This established our margin of safety.
If the company survives or do even better, we gain that price appreciation and we can sell it. A caveat to buying in high volatility is that there are companies that due to liquidity issues that they failed to take care of, they won’t survive. There will be those that will. You have to learn to identify the latter.
If the volatility is always so low, we could never be able to purchase with known margin of safety.
When we buy an investment in this low volatility, we have to really hunt hard to find unique proposition. In the absence of this, based on my Expected Return Model, we should be prepared to lighten up to a certain level at the first signs that the trend has changed.
I do not believe you could suppress volatility for an extended duration of time. The more you do it, the more we are likely to exacerbate the problem.
Volatility is The Truth. The second guest who manages a hedge fund that is still in this volatility trade explains volatility very philosophically and that appeals to me.
He explains that there is the real world and a fabricated world and volatility often peels off the fabricated world to revealed the truth. This is very profound.
Without volatility, or when you create a world that is less volatile you are essentially delaying the truth. To me the truth could very well be those poorer companies that we should be expelled out of the system. Since we do not have the mechanism to do that, it further encourages more companies that have poorer practice to be in the system.
There are profession or scope of work that carry out controlled volatility such as those who create artificial detonated avalanches so that the problem doesn’t snow balled to a bigger problem.
It is difficult to create controlled failures in the financial markets.
Volatility in life Promotes Growth to make the Long Term Quality Better and Easier. The couples that went for marriage counselling are the couples who are fighting in a controlled manner and the most likely to have their marriage saved. Those that lived in a tranquil-ed marriage are living in a passively aggressive world where the problems are not brought to the forefront.
Exercise and public speaking are long volatility activities. They are inherently difficult at the start or at the beginning but they bring you tremendous benefits over time.
Short volatility activities include excessive eating and drinking. They are very easy in the short run but they are problematic in the long run.
The interview ends with him sharing his very unique watch. This watch, instead of showing time forward, counts down the time you have on this earth based on your expected life span. So you just watch your life getting lesser and lesser.
We are an option (a financial derivative). We are expiring soon. It makes us ask about how rich we lived our life before we expires.