Does Complexity Breed Volatility?

We have now become familiar with the VIX, the Chicago Board Options Exchange Market Volatility Index, thanks to the wild stock market volatility that has graced our television screens in the last few weeks.  Investors process incoming political and economic news, and try to assess their future implications on investments and assets.  They do so with limited information and limited knowledge.

The  Financial Times shows that increased volatility is caused by large investors correlating their bets, essentially, as Telis Demos quotes Nicholas Colas, chief market strategist at ConvergEx: “All the people on the boat are running from one side to the other over and over again”.   Buyers and sellers all agree on the direction of the market and interpret the news in similar manners all at the same time.

I submit – without much proof I admit – that this behavior is driven, in part, by the temporary inability of buyers and sellers to grasp the future implications of some news on assets, because the system is too complex – and they simply cannot isolate the impact of the news on their World.

In normal times, investors have a systematic view of their World that enables them to process news (weather, politics, war) and figure out the potential magnitude of the impact on the assets in their care (stocks, bonds, commodities, infrastructure, etc.)  Some see the news as good, some may see the news as bad, each may use a different model to predict what the future will bring.   But the system has become so complex that it has become increasingly difficult to build a functional model that can tell us what the impact will be with some certainty.  Take the debt ceiling case, for instance.  Was there a likelihood that the U.S. would be downgraded?  And what would be the significance of that? And how would that impact other countries?  And how would that impact S&P and the value of their ratings in other countries?  And ow would it affect municipalities in the U.S.? and their creditors?  And how would it affect the U.S.’ competitiveness in the long run?  And how would that affect the U.S. election?  And how would that impact the U.S. stock market in the medium term? …..too much to process….

In the end, investors will give up and follow the herd: sell when they sell and buy when they buy…until the news cools down again, and we can decompose ourselves into smaller, less complex, manageable Worlds.

Oh, by the way… the same idea applies to political candidacies… and volatility in political ideology, but that should be the topic of another blog…