THE Oxford English Dictionary defines volatility as "being liable to change rapidly and unpredictably, often for the worst".
In the world of investment, volatility is one of many measures of risk and is determined by calculating the range of returns in any given asset class or market.
Looking beyond local turbulence, Scots investors should note that in recent months volatility has declined to historically low levels across all asset classes (equities, bonds, currencies) and throughout most geographies. While this in itself doesn't say anything about the likelihood of an imminent crash such as in 2000 and 2007, it does suggest a high degree of complacency among investors.
While there is much to be positive about as we survey the global market and economic horizon, there are also some darker clouds in the form of Ukraine and the Middle East which market participants are choosing to ignore, while some are suggesting UK equities will suffer a post-referendum depression.
There may be other reasons to suggest this period could be the calm before the storm. History suggests a low-volatile environment is conducive with a build-up of "leveraged speculation". As investors grow used to a lack of nasty surprises, they start to assume returns will continue at their current levels into the longer term. To enhance these returns, investors become comfortable taking on greater levels of risk. It is this complacency that sows the seeds of future financial instability.
The key questions here are: why has this fall in volatility occurred? Is it likely to persist? And what does it imply for investment strategy over the coming months and quarters?
Let's start with the why. Global central banks have kept interest rates at generational lows for a number of years, augmented with comfort blankets such as quantitative easing and other asset-purchase programmes.
In addition, we are at the stage in the economic cycle where growth rates are moderate and inflationary pressures minimal. These factors in combination pretty much explain why volatility is at its current low ebb.
But will this benign environment persist? And if not, what might cause it to change? Aside from the usual roster of geopolitical flashpoints (as noted above, a roster that has expanded somewhat of late) perhaps the likeliest catalyst will come from macro-economic developments.
One plausible scenario sees the ongoing economic recovery leading to an elimination of "spare capacity" and a build-up of inflationary pressures, both in labour and product/services markets. But measuring this spare capacity - the difference between demand and the ability of the economy to supply it - is notoriously difficult.
As a result, central bankers have to make estimates within a statistical fog. If they get these calculations wrong, interest-rate expectations and market responses could shift rapidly, leading to a spike in volatility across asset classes. What has further clouded the judgment of bankers and economists has been the use of quantitative easing.
The fact that quantitative easing, in all its guises, is a massive monetary experiment for which there is no instruction book leaves us particularly vulnerable to any lack of insight from policy-makers and and consequent policy errors.
While we have no real idea about when the prevailing benign investment landscape will change, it surely is a question of when, rather than if.
Some see heightened volatility as a negative. It is undoubtedly a source of uncertainty for those who are trying to plan for their financial future. But there is another way of looking at it. For those investing for the long-term, a certain amount of volatility is welcome.
Normal levels of volatility ensure risks are priced appropriately and while steep market dips can certainly be disconcerting, they do also offer opportunities to invest in good-quality companies or bonds at more attractive valuations.
Richard Dunbar is Investment Director at Aberdeen Asset Management
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