Wednesday, January 16, 2008

Prepared Speech on the Subject of Volatility

The following is from a speech prepared by Davide Accomazzo for the quarterly review of the Pepperdine Investment Club, a class which manages real money in a real portfolio.

Let me begin by thanking you for inviting me here tonight; it is an honor and a privilege.

This opportunity you have in running a portfolio with actual money is a great tool to become acquainted with the true meaning of portfolio management. When I took my investment classes in business school, part of the program was to individually manage a $100,000 portfolio for the duration of the class. Whoever had the best performance would win…

Of course, this was not “real” $100,000, which in my case was rather good since after spending about half the class comfortably at number one, I decided to take a leveraged bet on the dollar index just before the U.S. Government shutdown in 1995. From there, I miserably dropped from first place to last place, where I concluded the class.

Later, when I called my professor to tell him that I was going to Wall Street to trade euro convertible bonds for an investment bank, he said, “When I saw you blow it all up with that trade, I knew you were going to go to Wall Street!”

Well… ten years later and after dodging many bullets, with real respect for risk and volatility, and a much better understanding of risk management and discipline, I can say that blowing up that hypothetical portfolio was a worthy experience. Because of this, I would like to touch upon the subject of volatility, and hopefully provoke interest as well as more analysis on your part in your quest to become money managers.

Many years ago, a friend of J. P. Morgan, at the time the most powerful banker and investor in America, if not the world, asked him what his outlook for stocks were for the coming year. The legend states that J. P. answered, “Stocks will go up and stocks will go down.”

Such a seemingly overly-simplistic comment probably disappointed Morgan’s friend but in reality it was the truest analysis Morgan could have given. Even today, with all the advances in quantitative science and the power of technology, the “tea leaf reading” activity in guessing market direction is still, at best, a matter of batting averages and discipline. In other words: stocks will go up and stocks will go down.

What I believe is of utmost importance, and often underestimated, is a clear understanding of the potential violence of those swings; how deep stocks might go down and how high stocks may fly. I am referring to stock market volatility. The process of incorporating volatility analysis and volatility forecasting in portfolio analysis is in my view of paramount importance.

There are many ways to refer to such volatility and one now commonly used benchmark is the VIX, a measure of market volatility calculated by averaging the weighted prices of out-of-the-money puts and calls on the S&P 500 index.

While this benchmark was confined mostly to derivative players for years as an analytical tool, it has recently come to the forefront. I believe that an understanding of how the VIX illustrates and maps market participants’ risk behavior can only improve your portfolio management technique.

There are also lessons to be learned from studying volatility behavior in its historical contexts. One should always be on the lookout for warnings flags as indicated by irrational market behavior—the madness of crowds—as well as disconnections between implied and statistical volatility.

The past is littered with examples: absurdly low volatility levels in 2006, followed by a slew of blow-ups in 2007 including subprime hedge funds, CDO mispricings, and quant hedge funds are recent cases in point. Going just a few years back, there is the 2001-2002 bear market volatility spikes, and before that is the 1998 LTCM volatility convergence trade fiasco.

Consequently, you should imprint onto your psyche the potentially misleading significance of Gaussian calculations in trading, and in turn focus on the importance of volatility cyclicality, the value of common sense, and the need for strategic insurance.

Always ask yourself: Am I being paid enough for the risk I am taking?

Or, on the other side of the coin: Are opportunities undervalued given the market’s structural and behavioral profile, and should I increase exposure?

And always keep in mind the effect of the unforeseen event, now commonly referred to on trading desks as the “Black Swan.” How you can protect your portfolio, or likewise profit from it… because that is or certainly should be, why people pay you to be their money manager.


- Davide Accomazzo, Managing Director

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