The smoother the road, the faster people are likely to drive. The faster they drive, the more excited they are about getting to their destination in good, if not record time; but, also, the greater the risk of an accident that could also harm other drivers, including those driving slower and more carefully.
That is an appropriate analogy for the way unusually low financial volatility influences positioning, asset allocation and market prospects. And it holds for both traders and investors.
The lower the market volatility, the less likely a trader is to be “stopped out” of a position by short-term price fluctuations. Under such circumstances, traders are enticed to put on on bigger positions and assume greater risks.
What is true for one trader is often true for firms as a whole. Moreover, the approach is often underpinned by formal volatility-driven models such as VAR, or value at risk, that give the appearance of structural robustness.
Patient long-term investors can also be influenced by unusually low volatility, whether they know it or not. Expected volatility is among the three major inputs that drive asset-allocation models, including the “policy portfolio” optimization approach used by quite a few foundations and endowments (the other two variables being expected returns and expected correlation). As the specifications of such expectations are often overly influenced by observations from recent history, the lower the volatility of an asset class, the more the optimizer will allocate funds to it.
All this is to say that the recent decline in both implied and actual measures of volatility, including a VIX that recently touched levels not seen since 1993, is likely to encourage even greater risk taking both tactically and strategically, including bigger allocations to stocks, high yield bonds and emerging market assets. And both, at least in the short-term, will contribute to damping market volatility further.