‘We Need To Re-Evaluate Our Understanding Of Volatility’: The Babadook Revisited

9 thoughts on “‘We Need To Re-Evaluate Our Understanding Of Volatility’: The Babadook Revisited”

1. So essentially the further the two are apart… economic downside and fiscal support upside the more rapid and violent volatility becomes while it also becomes less apparent until the snap to the other reality. Like playing with the lever on an electric chair you can move it around a bit without anything happening but then all the sudden you make contact and now someone is dead. Volatility is either absent or catastrophic.

   1. calh0025
      The phenomenon you are describing is something French mathematician Rene Thom called a “catastrophe” in his ground-breaking work, Catastrophe Theory. The “snap” you refer to is the key characteristic of a catastrophe in his theory. The exact timing for a catastrophe is also essentially beyond mathematical prediction.

      This article once again emphasizes the reasons why people like me should stay the hell away from the market esoterica it describes. The sheer speed, size, and complexity of these market mechanisms are simply not for anyone with limited funds and less than fully sophisticated tools.

      It just struck that the evolution of financial markets is comparable to changes in the world of physics in my relevant lifetime. When I was a student there were electrons, protons and neutrons with some hints there might be subparticles. Now we have CERN, based on a standard model of matter with dozens of subparticles, a competing string theory model and only a couple hundred folks who “get it.” No country for old men.

2. Great read, thank you. Last paragraph mentions convexity as the 4th moment… it’s kurtosis.

3. Insightful – thanks for sharing these concepts

4. Thank you for this article. It is most enlightening for me.

5. Thanks! I wonder how many investment committees at most endowments & foundations are able to explain this stuff to their boards?

   That’s why the consultants exist, I guess.

6. Sometimes there is money to be made when the tails are fat, even if overall volatility is relatively low.

   My Chinese friends strongly advised me to avoid punting at the Macao Trotting Club. It quickly became obvious why – nice fat outcome tails, sadly reserved for those on the inside.

   Now, I’d be able to start a fund betting on the favorites and call it an “investment” vehicle!!

7. Some day I hope VaR gets retired.

   Fundamentally risk s loss. Does a business and therefore (hopefully) the stock add value (free cash flow) and reduce risk or does it use cash and destroy value (leading to real risk).

   Vol is opportunity for fundamental guys. We have the ability to buy or sell on “risk”. Of course one has to know “value” or business models and of course valuations.

   Of course this is such old school thinking for modern mkts whose tails (which are always fatter than we all think) wag rationality.

   Computers may think a utility with a 3% yield growing 2% a year with a stock vol of 15 is more attractive than a 4% FCF company growing 10% with competitive advantages but a stock vol of 22 but some of us will take the other side and try to convince our investor base why.

   The beauty (and huge advantage) many of you individual investors have is you can use this common sense to outperform and use “risk” as an advantage and outperform with longer term time horizons.

   Sure there is a reflexivity aspect to vol impacting fundamentals and yes that is a true risk (of loss of capital) but buying and selling at good margins of safety should help protect and enhance.

   Good luck, be smart, and trade well.

8. Just thinking that the global equity market has evolved into a negative convex beast supercharged by pro-cyclical liquidity and a not well understood dynamic that the article elucidates. Preaching to the converted, but useful charts and analysis.