Volatility is Back!

Stefan Leins

Volatility Is Back! – A Good Time to Think About the Notion of “Stability” in Financial Markets

Since the beginning of this year, we have experienced what some market commentators have called the “return of volatility.” Market prices have started to rise and fall quicker than before and the volatility index (VIX) has spiked. After years of relatively stable growth, market participants seem to have become more concerned about the future of price developments again. This is a good time to critically reflect on the notion of stability in financial markets.

In the aftermath of the global financial crisis in 2008, it soon became clear that one of the most pressing issues to policy makers and market authorities was to reinstall “stability.” Stability, many argued, was the precondition to be reached for bringing the markets back on track. What was forgotten back then – and still tends to be forgotten today – is that long term stability, as a condition of financial markets, is by no means an ideal condition to all market players.

For actors interested in governing markets, a certain degree of stability is of course important. For individual investors interested in increasing their wealth in the long run, stability is a positive feature as well. For institutional investors such as hedge funds, or even for individual investors with a larger risk appetite, stability, however, can also mean a lack of investment opportunities. If prices of stocks, for example, remain stable over a longer period of time, there is little room to gain money by betting on diverging future scenarios.

Therefore, market practitioners often state that less risk also means fewer opportunities for financial gains. And as sociologist Jens Beckert reminds us, financial markets – unlike many other institutions – can destabilise, rather than stabilise future expectations. How is such destabilization achieved? It is achieved through real time movements that reflect competing expectations of how markets will develop in the future.

Markets are not made to foster planning. Rather, they are constructed to serve as an arena in which diverging scenarios of potential future developments compete. Many economists argue that, based on forces of supply and demand, markets create stable prices in real-time, but we actually see that prices can quickly change in the short-run. Here, the market itself is the ultimate authority that determines such future developments.

Financial markets do not produce long-term stability, but instead continuous competition and volatility; this is relevant for talking about finance and stability. While some market actors may want increased stability, others want financial markets to be a destabilizing force that allows them to compete over diverging future scenarios. Here, the role of economic models and financial predictions comes into play. It is well known that financial predictions often fail to accurately predict future developments in the market.

In 1933, economist Alfred Cowles published a paper that empirically tested the attempt to forecast stock market prices. After having analysed thousands of stock market predictions from 16 financial service agencies, Cowles came to the conclusion that “statistical tests of the best individual records failed to demonstrate that they exhibited skill, and indicated that they more probably were results of chance.”

Such results have been confirmed repeatedly. Orlando, a ginger cat that tapped over the pages of the Financial Times to select stocks, outperformed human investors in 2012. Competing against a group of financial professionals and a group of novice students, the cat generated the highest financial return of all the three teams.

Given this lack of accuracy of financial predictions, what is the role of forecasting in financial markets anyway? As I have illustrated in my book, Stories of Capitalism, financial analysts see their role in producing competing scenarios in the ever-changing environment of financial markets. In doing so, they provide investors with the tools to bet on these diverging scenarios. Of course, these investors do so to increase their profit, and many are aware that this means taking considerable risk. The outcome of such practices of betting on competing scenarios is not stability, but an environment of radical uncertainty. Planning and accurate predictions are made impossible by the flexibility of investments and the velocity of adaptation of ever-changing scenarios fostered by investors.

If we talk about stability, we should not forget that stability is not considered to be an ideal condition by all actors in the market. This is why all efforts to increase stability, such as the regulations of Basel III, are criticized by at least some financial market actors. The question then focuses on how to protect the actors dependent on financial stability from the efforts of the ones that aim to destabilize markets?

This would mean describing the intentions of the different groups of actors in the market. However, it is also important to move from discourse to practice in our analysis. Actors might say that they are interested in stability, but still use practices that primarily destabilize markets. The notion of financial markets as a destabilizing institution might even sound totally unfamiliar to these actors. But on a practical level, they actively contribute to this destabilization, which makes the planning and minimizing of risk impossible.