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Who Benefits from Volatility?
Old 10-13-2008, 11:11 AM   #1
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Who Benefits from Volatility?

The recent market gyrations have started me thinking about market volatility, the response of the "average" investor, and who benefits from this situation.

Most institutional investors, such as private wealth management, dynastic/institutional trusts, pension funds, universities, etc. do not panic and sell their equities during market drops. In fact, most of these investors have significant cash reserves which are used to purchase cheap equities during market drops. When this happens, this results (long-term) in a large transfer of wealth from the uninformed small investor to larger, more sophisticate investors. I am doing this myself.

I have to wonder if some of the forces pushing 401(k)'s and other self-directed investments by "Joe Six-pack" consider this when lobbying the government. I suspect that one could show that sophisticated, long-term investors gain larger returns with high volatility than with lower volatility. Buy on panic, sell on euphoria.

Am I wrong?
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Old 10-13-2008, 11:23 AM   #2
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For buy and holders there is no advantage to volatility.

Advantage goes to dollar cost averagers and to ("the smart") traders.

Dis-advantage goes to people (like retirees) selling regularly to meet their income needs and to ("the not-so-smart") traders.
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Old 10-13-2008, 11:25 AM   #3
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The traders benefit the most..........
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Old 10-13-2008, 11:34 AM   #4
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For buy and holders there is no advantage to volatility.

Advantage goes to dollar cost averagers and to ("the smart") traders
I think buy-and-holders who rebalance according to a fixed asset allocation model can gain some advantages as well.
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Old 10-13-2008, 11:47 AM   #5
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Advantage goes to asset allocators who rebalance periodically.

Audrey
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Old 10-13-2008, 11:58 AM   #6
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+2 ( or +3?) to the rebalancers. Volatility helps.

And I'll say it again since it is relevant. I simply don't understand those who choose to rebalance according to the calendar. Rebalancing is a math function (X% out-of-whack), not a function of the seasons.

What are the odds that a an X% rebalance trigger is also going to co-incide with a date picked in advance on a calendar. I just don't get that.

I did some rebalancing from a stodgy bond fund to the S&P on Friday. So we will see, but the (meaningless) instant gratification I'm getting today at least feels nice.

I wish I would have stuck to it when I got my AA on the high side with stocks a while back, I would have done even better. Still learning to be disciplined.

-ERD50
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Old 10-13-2008, 12:30 PM   #7
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That may be true, ERD50 (about the seasons)

But with October being such a peak or trough month, it sure is tempting to make Oct 15 the annual rebalance date

And I'm a delta (% out of whack) rebalancer! The problem with delta triggers is they can be triggered multiple times on a fast ride down. You also gotta have a way to string it out.

Audrey
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Old 10-13-2008, 12:38 PM   #8
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That may be true, ERD50 (about the seasons)

But with October being such a peak or trough month, it sure is tempting to make Oct 15 the annual rebalance date

And I'm a delta (% out of whack) rebalancer! The problem with delta triggers is they can be triggered multiple times on a fast ride down. You also gotta have a way to string it out.
Indeed. And although I try to use a hybrid approach between scheduled and percent-off-target rebalancing, when you mention about the "ride down" (or up in theory) is much of the reason why Bill Bernstein recommended a fixed period of time -- usually 12 to 18 months.

The theory is that you don't want to rebalance so infrequently that the asset class that have performed the best since rebalancing have time to revert to the mean, and you want to make the rebalancing infrequent enough that currently "hot" asset classes have time to run. In other words, the short-term tendency for asset classes is to continue in the same direction, but the long-term tendency is to mean-revert. To Bernstein, finding an optimal period of time was a search for the "happy medium" holding period between rebalances. And in running numbers, Monte Carlo simulations of asset classes and such, it seemed like close to 18 months was the optimal time period between rebalancings. At least that's my recollection of Bernstein's general findings.

Having said that, my hybrid approach is to rebalance whenever an asset class gets out of whack by more than a certain threshold -- but not more than once every 90 days in any given class, since nearly "continuous rebalancing" could, in theory, eliminate all of its buy low/sell high benefits.
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"Hey, for every ten dollars, that's another hour that I have to be in the work place. That's an hour of my life. And my life is a very finite thing. I have only 'x' number of hours left before I'm dead. So how do I want to use these hours of my life? Do I want to use them just spending it on more crap and more stuff, or do I want to start getting a handle on it and using my life more intelligently?" -- Joe Dominguez (1938 - 1997)

RIP to Reemy, my avatar dog (2003 - 9/16/2017)
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Old 10-13-2008, 12:52 PM   #9
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Good points. However, if you rebalance at (say) 5% out-of-whack points, even if you have to do it three or four times over the course of a run up - it's kinda like DCA. You only moved that 5%, not the whole thing at once. So the majority of the investment still saw the run up.


I do plan to study up on the details more. I'll check out Bernstein's site, but I have a feeling I'm going to put together a spreadsheet and macro before this is over...

-ERD50
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Old 10-13-2008, 01:01 PM   #10
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With my allocation, a 5% stocks/FI out-of-whack only requires about a 10% market move to be triggered. Well, this year that happened 4 times. Two of them in the same week!!!!

Somehow, that just seems like way too often.

Audrey
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Old 10-13-2008, 01:04 PM   #11
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The investors who most directly benefit from volatility are those holding options. Higher volatilty = higher options prices. Even if you don't currently own options, if you want to write your own options and sell them you could also take advantage of the higher volatlity in the higher premiums you would receive. But of course, it's not without risk.
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Old 10-13-2008, 01:09 PM   #12
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The investors who most directly benefit from volatility are those holding options. Higher volatilty = higher options prices. Even if you don't currently own options, if you want to write your own options and sell them you could also take advantage of the higher volatlity in the higher premiums you would receive. But of course, it's not without risk.
I rarely dabbled into options -- the one time I did is when I was writing covered calls on some of my tech holdings in 1999 and 2000. A stock selling for 200 might have an out-of-the-money 220 option selling for something like 15.

So if someone had 100 shares at 200, they could write one contract and pick up $1500. And if the stock didn't rise to 220 in the next couple of months, it expired as pure profit.

About half of my tech stocks were liquidated between mid-1999 and mid-2000 this way when some of them spiked up to be in the money. But in the end it was a nice low-risk income play while it lasted, and I did get stopped out of many of those holdings before the carnage really began.

It was kinda fun, but I don't think I'd do it again.
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"Hey, for every ten dollars, that's another hour that I have to be in the work place. That's an hour of my life. And my life is a very finite thing. I have only 'x' number of hours left before I'm dead. So how do I want to use these hours of my life? Do I want to use them just spending it on more crap and more stuff, or do I want to start getting a handle on it and using my life more intelligently?" -- Joe Dominguez (1938 - 1997)

RIP to Reemy, my avatar dog (2003 - 9/16/2017)
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Old 10-13-2008, 02:37 PM   #13
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Technical Analysts benefit from volatility. I don't do TA myself, but I believe it is good for one thing: trading off of investor psychology. People get emotionally triggered by certain market patterns. The TA'ers build mathematical models that predict what emotional selling or buying will occur, based on studies of historical data. Then they execute trades to gain what the emotional traders are losing.

Another way of saying it is that it's the arbitragers who make money on volatility. The arbitragers trade when certain market characteristics get out of whack, i.e. investor sentiment opposite of market fundamentals. They are essentially betting that those characteristics will revert back to their usual relationship, i.e. investor sentiment consistent with market fundamentals.

This is why I believe that it's important to think twice before doing any investment that is influenced by emotional reactions, especially if it's the conventional emotional reaction. There are plenty of TAs and arbitragers waiting at all times to snatch up the spoils of such emotional trades.
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Old 10-13-2008, 02:52 PM   #14
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pretty much

one of the most simple TA tools is called MACD. it's 3 lines which are 12,26 and 9 day averages. easiest way to spot capitulation.

in a downtrend the macd trends down. at some point the prices rise and so does the macd. then prices will plummet again but faster to a lower level than the last low. but in this case the MACD line is higher than the previous low because the prices dropped too fast for the averages to catch up. prices turn around again and head higher.

on a chart you would see a lower low on the market prices, but a higher low on the macd. it's not 100%, but around 90% accurate in predicting an awesome buying opportunity like in October 2002 when compared to the low of July 2002. all the weak willed were selling, but if you were watching Apple, RIMM and a few other tech names you would have make a killing along with buying plain index funds

also works for spotting tops like oil prices earlier in the year when the shot up from $100 to $150

current MACD looks more like late 2001 and july 2002 so i don't think this is the bottom
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Old 10-13-2008, 02:52 PM   #15
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With my allocation, a 5% stocks/FI out-of-whack only requires about a 10% market move to be triggered. Well, this year that happened 4 times. Two of them in the same week!!!!

Somehow, that just seems like way too often.

Audrey
Well, it might seem like too often, but is it? What other strategy would have worked better over a few peak trough cycles?

This is what I want to study, and hopefully come to some conclusions.

-ERD50
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Old 10-13-2008, 04:57 PM   #16
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Yeah traders generally benefit, but mainly when stock prices jump around a bit and settle close to where they started. Currently the volatility index seems to be in unchartered territory so I think the risk is harder to quantify......so lots of trades are triggered and the brokers make money on every transaction.

I had a managed futures account for awhile.....I luckily dumped it before it went into a slump, but YTD thru Aug it was up 13.6%. I suspect they gave back all thier gains in the past few weeks. They have not posted Sept results yet..........I'll keep checking!
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Old 10-13-2008, 05:01 PM   #17
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High vol benefits VIX traders on the CBOE.
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Old 10-13-2008, 05:06 PM   #18
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I really don't know the answer. I don't mind "doubling down" once, but when the third or fourth time comes around in one year, I start to feel nauseous. On Tuesday of last week, I had finally waited until I was over 2X my trigger, and I rebalanced again - but it was only a partial rebalance - in those funds most out of whack.

I was only half joking when I said I might just let Oct 15 be the only day for a delta rebalance. I almost always do something in Jan because I have extra cash from the Dec distributions. I take most of these in cash to pay taxes on the account.

If you figure out some recommendations from historical studies, let me know. For myself, I have to handle my gut as well as my portfolio, so I have to figure out what "feels" OK enough, and balance that with what is optimal from a historical perspective.

Audrey
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Old 10-13-2008, 05:50 PM   #19
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I
I was only half joking when I said I might just let Oct 15 be the only day for a delta rebalance. I almost always do something in Jan because I have extra cash from the Dec distributions. I take most of these in cash to pay taxes on the account.


Audrey
too bad....I thought the Oct 15 thing was a great idea! Sept/Oct seem to be volatile, so I might actually go with Aug. I have often thought why January?, but I guess its convenient for me since I spend time over the holiday to figure out where things stand.
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Old 10-13-2008, 05:57 PM   #20
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Well - my hand is usually forced to rebalance, at least some, in January because I use Dec distributions to rebalance some after taking what I owe for taxes out of the portfolio.

FWIW - every time I've rebalanced in the summer - and that includes Aug - I've regretted not waiting until Oct. That is my personal anecdotal evidence, but it's been true several different years since 2000.

I'm half serious about the Oct 15 idea - if my trigger is % out of whack Oct 15, then rebalance. Sit on my hands rest of the year.

Who knows......?

Audrey
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