Volatility Analogy

Today Heidi Moore interviewed me for NPR Marketplace.  I won’t give away what it is about, but I will tell you two things:

  1. If I am on Marketplace, it will be on Friday or Tuesday.
  2. There was a point in the interview where she stumped me.  I’m usually pretty able to think on my feet, but when she asked me “Volatilty: can you explain that in language that a teenager could understand?”  I choked up, did my best on short notice, and gave what I later viewed as a lame explanation, but as I said it, my heart sank, because I realized I was not clarifying anything.

So, after the talk (It was really good to meet Heidi voice-to-voice for the first time), I took a walk outside and pondered.  Then the analogy struck me, and here it is:

Imagine you are driving down a well-engineered smooth road with gradual turns, modest traffic, and no bad weather, and you are going 60 miles per hour.  This is easy.  There is no volatility here.  That is what an average retail investor hopes for, and rarely gets.

Now consider a road that is not so smooth, with significant and frequent curves, significant traffic, and now and then it is raining hard.  That is a difficult situation.  This is similar to what the market is normally like, with all of the volatility (high variation of results).  Maybe you can’t do 60 MPH in that environment, but something less.  Those who recognize risk must run at a slower speed or risk accidents.

Now think of someone without special skills who dares to drive the easy road at 100 MPH.  He might not think it so hard, and might think he is quite a driver doing so.  So it was for equity investors in the ’80s and ’90s; conditions were uniquely favorable, and average investors thought they were hot stuff.

Now think of someone without special skills attempting to do the hard conditions at 100 MPH on average.  Odds are they wipe out, or even die.  You can’t fight physics, or can you?

Okay, now think of a highly trained driver with a special car that is able to handle the hard conditions, and can do it at 100 MPH on average, most of the time.  It doesn’t work all of the time, because there are things no one can catch — extra slipperiness, a bump in a particularly bad place that leads to an overturned car.

Finally, think of the trained driver with special car told he must average 150 MPH over the hard conditions course once.  He dies on the first try, destroying the car.  Several other trained drivers try with identical cars.  They all die, and the cars are destroyed.  Eventually, you can’t get anyone to try the hard conditions course at 150 MPH.

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In my analogy, the difference between the hard and easy course is volatility: how rough/variable are conditions.  Leverage is represented by speed.  Any course can be completed, but there is a maximum speed for which a course can be completed without disaster.  No surprise that those who are overly aggressive in investing frequently fail.

Now for the final tweak: imagine that you have no map for the hard course, it is new to you, no GPS, nothing to aid you in the driving.  That is what the markets are like.  As I often say, the markets always have a new way to make a fool out of you.  How fast could you go?  How fast could the trained driver with a special car go?

This is why I urge caution in investing and avoiding leverage.  Investing is tough enough without trying to earn something beyond what the market can bear.  I encourage safety first, after that, look for best advantage.

5 Comments

  • Conscience of a Conservative says:

    That is a tough one. I would’ve discussed the weather. We could have any temperature , amount of rain or sun but we’re not sure, and the degree to which we’re not sure represents volatility. Now compare San Diego to NY to Nelson New Zealand to Washington DC and you might conclude that the next week’s weather in some places is more certain than in other places.

  • Helical_Investor says:

    I am a chemist by background and thus never cared for the term volatility as applied to investing / markets. In chemistry, volatility relates to a liquids propensity to evaporate. Since many of the ‘highly volatile’ solvents are also flammable, they can often be dangerous. So, volatility is really a metaphor implying ‘potentially dangerous, and where profits are prone to evaporation’.

    I would have answered the question as ‘It is a measure of stock price variability that tells an investor how likely the security is to test ones emotional instincts. Highly volatile stocks can frequently challenge our inherent behavioral biases making them more difficult to own effectively.’

  • James Dailey says:

    Hello David – I hope you and your family are well.

    I blend the metaphor of earthquakes with the business cycle. During expansions stocks tend to rise with occassional tremors (3-5% reactions), less frequent small quakes (5-7%), and one or two medium sized quakes (corrections of 10-20%). The longer markets go without these normal bouts of instability, the greater the chances of a hyper critical state being reached, from which a large earthquake explodes. Seemingly stable conditions drive complacency and leverage, which increases criticality and makes the system increasingly less stable. In my opinion, the key to understanding volatility is monitoring the relative criticality of the market. When criticality is low the chances of large volatily is small, and vice versa.

    For example, present market conditions display a level of hyper criticality which are rarely reached. While the timing of the earthquake is unknowable and the system can grow even more critical, once this condition is reached a significant earthquake is all but assured.

  • cold.as.ice says:

    When we homeschooled we used “Whatever Happened to Penny Candy?” (An Uncle Eric Book) for the economics with kids at age 8 or 10. It covered velocity and volatility and did a great job.

    It remains my go to source for economics explanations.

  • Conscience of a Conservative says:

    Another aspect of vol. which is often mis-understood is the difference between implied and realized volatility.

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