The Financial Philosopher: Weekend Wisdom: Uncertainty, Volatility & the 'VIX'

"When the mind is in a state of uncertainty the smallest impulse directs it to either side." ~ Terence

Emotion among stock market participants this week was intense so I thought it appropriate to continue our weekend review of human behavior. This week we'll observe the powerful state of uncertainty and its relationship to market risk and volatility...

Investment risk, put simply, is the chance of losing money or, expressed in financial vocabulary, of "declining share value." For all of you math and statistics fans, investment risk can be described in terms of the "standard deviation" in returns, which can also be considered a basic statistical measure of uncertainty...

The simplest way to think of standard deviation is in terms of the fluctuation, or "ups and downs," in stock prices. For example, if the S&P500 averages 10% return per year with a standard deviation (fluctuation) of 15% per year, it is reasonable to expect a "normal" year as having returns somewhere between 25% (10%+15%) and -5% (10%-15%). "Abnormal returns," then, would naturally be higher than the normal high of 25% and lower than the normal low of -5%. These abnormal returns may often be directly correlated with high levels of uncertainty and its relative, volatility...

The easiest way to visualize uncertainty in the stock market is to look at the Volatility Index, or "VIX," which reflects market expectations for near-term volatility in the S&P 500 and is most commonly used by "technical traders" who typically trade options based upon graphical trends in stock market fluctuation. The VIX value is a form of the implied volatility in the current options for the S&P500. When people buy or sell options, they are implicitly betting on the future volatility of the thing that they are buying options on. This is a complex and seemingly illogical concept... You don’t need to understand options, however, to appreciate what the VIX shows. Take a look at a recent VIX reading:

It is interesting to note that volatility readings are currently approaching the 40 range, which has marked recent "bottoms" for stock prices. Technical traders are beginning to take notice and struggle with this now...

While I do not participate in technical trading, I find its human behavior aspects quite interesting. Since high levels of volatility, or large swings in market prices, largely represent uncertainty, then traders are essentially "betting" on the fallibility of human emotion. The trader not only must have a grasp for reading technical charts but they must be skilled at reading the emotions, or "sentiment," of the investor herd. But here's where it gets interesting: The trader most importantly must be aware of their own emotions and resist falling into the same "uncertainty" trap as the investor herd.

"It is the mark of an educated mind to rest satisfied with the degree of precision which the nature of the subject admits and not to seek exactness where only an approximation is possible." ~ Aristotle

While I respect a few traders, such as Dr. Brett, a Psychologist, at TraderFeed and Charles Kirk, who has a philosophy degree, at The Kirk Report, I find it illogical to make an attempt at quantifying something that is not quantifiable.

Consider these words that make sense to me (here's the complete article, which is definitely worth a read):

Risk and uncertainty are two concepts that emanate from randomness. Neither concept is fully understood. Although risk is quantifiable, uncertainty is not. Rather, uncertainty arises from imperfect knowledge about the way the world behaves. Most importantly, uncertainty relates to the questions of how to deal with the unprecedented, and whether the world will behave tomorrow the way it behaved in the past...

For instance, once bicyclists were encouraged to wear helmets, the relation between riding the bicycle—the cause—and the probability of suffering a head injury—the effect—changed. You might simply think that the introduction of helmets would have reduced the number of head injuries. Rather, the opposite happened. The number of head injuries actually increased, possibly because helmet-wearing bikers started riding in a more risky manner due to a false perception of safety. Paradoxically, the causality between riding the bicycle and suffering a head injury changed because we started managing the observed health risk based on the previously observed relation of cause and effect.

Perhaps the fact that uncertainty and human emotion are not quantifiable and, more importantly, not completely within our control, explains why a small percentage of traders are quite successful while a large majority fail to beat the market averages.

Are there any traders out there who can comment, clarify or correct my assumptions? For the remainder of my readers, what are your thoughts? Do emotion and science belong in the same equation?

Don't "think" too hard about it! Just enjoy your weekend and try not to concern yourself with short-term market conditions...

TFPAuthor, Kent N. Thune, QPFC, is the President and founder of Atlantic Capital Investments, LLC (ACI), a 'fee-only' financial planner and Registered Investment Advisory firm located in Mount Pleasant, SC