How stocks and bonds react to rising volatility

(MoneyWatch) History offers important insights into the behavior of stocks and bonds, and the evidence falls right in line with what economy theory would predict.

Because investors are typically risk-averse, we should expect a positive relation between expected returns and expected volatility -- the greater the expected volatility, the greater the rate of return required. Conversely, we should expect to see a negative relationship between returns and unexpected volatility as investors increase the discount rate they use to value future expected earnings on risky assets. Investors also typically flock to safe assets during periods of heightened uncertainty (what's called a "flight to safety"), even accepting lower expected returns in exchange for safer assets.

The historical record shows that volatility does in fact spike when we experience high levels of uncertainty. And since investors dislike risk, they require higher expected returns to compensate them for the increased uncertainty and volatility. The result is that spikes in volatility are typically accompanied by sharply declining stock prices. We see that when we look at the four largest volatility spikes:

• October 1929 -- stocks returned -19.6 percent
• July 1933 -- stocks returned -9.6 percent
• October 1987 -- stocks returned -22.5 percent
• October 2008 -- stocks returned -18.5 percent

Jim Davis, vice president of Dimensional Fund Advisors, examined the average returns of various asset classes during periods when volatility jumped. His study covered the period 1927-2011. Davis found that while the average monthly return to the total stock market was 0.9 percent, the return averaged -2.9 percent in the month containing volatility jumps. However, the following month saw an average return of 1.4 percent. The return over the three months following the jump was 1.2 percent, still 31 percent greater than the average return. He found similar results when he looked at the results for small and value stocks.

Small-cap growth stocks averaged a monthly return of 1 percent. During the months when volatility spiked, the return averaged -4.7 percent. The average returns for the following one and three months were both 1.9 percent.

Small value stocks averaged a monthly return of 1.5 percent. During the months when volatility spiked, the return averaged -3.4 percent. The average returns for the following one and three months was 2.5 percent and 1.9 percent, respectively.

Large growth stocks averaged a monthly return of 0.9 percent. During the months when volatility spiked, the return averaged -2.7 percent. The average returns for the following one and three months was 1.1 percent and 1.2 percent, respectively.

Large value stocks averaged a monthly return of 1.2 percent. During the months when volatility spiked, the return averaged -2.3 percent. The average returns for the following one and three months was 2.2 percent and 1.4 percent, respectively.

In each case, the returns turned negative in the month of the jump in volatility. Davis concluded: "The overall negative relation between volatility and return that some observers emphasize seems to be driven by the unexpected component of market volatility."

However, we also find that in each case returns were much greater than the historical average in the following one- and three-month periods. We also saw that the returns of small stocks were hit harder by the volatility spike than were the returns of large stocks, and that the returns of growth stocks were more negatively impacted than were the returns of value stocks.

Davis also confirmed the diversification benefits of safe fixed-income investments. The average monthly returns on five-year Treasury bonds jumped from 0.45 percent to 0.68 percent, and from 0.49 percent to 0.64 percent for 20-year Treasury bonds, during months when volatility spiked. However, while the average monthly return on riskier long corporate bonds was still positive in the months of volatility jumps, the average return fell from 0.51 percent to 0.34 percent. The safest bonds provided the most portfolio stability just when it was most needed.

The most important conclusion to draw from Davis's research is that if you want to reduce portfolio sensitivity to surges in stock market volatility, combining the safest bonds with stocks is the most effective solution.

Image courtesy of Flickr user 401(K) 2012