Without understanding current levels of volatility, it is impossible to put day-to-day or week-to-week returns on the stock market into perspective. Do you know when you should be concerned and when you shouldn’t?

If we refer back to my last column (Why we need to understand volatility), I presented a chart with the different regimes of annualised volatility clearly marked.

In the chart below, I show the same sort of information, but in a different guise – these are the weekly returns on the ASX200. The different stages of volatility, known as regimes, are shown in different colours and the dotted parallel lines are reference lines for when volatility reaches ±2% and ±4%.

Chart: Weekly returns on the ASX200

In this metric of weekly changes, the volatility regimes that move in a 12% range (that is, the gold and grey) can be interpreted as most weekly changes were within the bounds of ±4%.

In the quiet (green) regime, nearly all of the weekly returns were within ±2%. Therefore, when the grey regime came along, it was quickly noted that the green regime had ended as the -2% bound was sharply breached. Importantly, that meant that gearing levels (for those with a margin loan outside of super) should be reduced back to normal levels and equity exposures might be pegged back a little.

Interestingly, the grey regime was asymmetric, that is +2% was rarely breached but -2% was often breached. We believed at the time this was due to the short-run bubbles in equity prices that were probably associated with investors setting up super funds under the new rules to begin in 2007. As money piled into equities, prices were ramped up for a month or two before a small, sharp correction got the market back on track.

Of course, the range of weekly returns blew out in late 2007 and 2008. The ‘unexpected’ was the order of the day and it was unlikely that the market could establish a rally until this level of volatility (or risk) subsided.

Where we are now

The blue regime, which has been in place since the start of 2010, has now settled down and all recent weekly returns have been less than 2% in magnitude. This calm market state means that a rally might more easily be sustained than when the market was twitchier and equity exposures might be increased on the basis of a risk-return trade-off with other asset classes.

Thus, we now have a reference for assessing what constitutes a big market move and what action we might consider taking. In the next issue, I will introduce three other measures of volatility which help us better understand how to manage a share portfolio.

Ron Bewley, Executive Director, Woodhall Investment Research.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should, before acting, consider the appropriateness of the information in regards to their objectives, financial situation and needs and, if necessary, seek professional advice.