Risk Management 101: Volatility and Time

In financial markets, volatility and time are two sides of the same coin.

The more volatile the asset, the greater its price swings – that is what ‘volatility’ means in finance. The longer the time period over which you observe the asset, the more opportunity there is for the price to move and jump around, and the greater the volatility we should expect over that period. More time means more volatility – always.

Speaking of coins…

If you flip a coin 10 times, you are very unlikely to get 10 heads in a row. But if you flipped it every second and you didn’t stop, you would eventually get there. It wouldn’t even take that long to get to 10, and if you kept going, you would eventually get to 20 heads in a row, or 50 heads in a row, or even 100. It would probably take you a billion years to get a run of 100 heads (or tails) but if you had the time and the patience, you would eventually get there.

Looking at it from the opposite perspective, if you picked up a coin and flipped it 10 times, you might expect the longest run (either heads or tails) to be 3 or 4. If you flipped it 100 times, the longest run might be 7 or 8. Flip it 1,000 times and you might get into double figures. As the length of the run increase, the number of flips required increases exponentially, which is why it would take so long to get 100 in a row.

Still, the more you flip the coin, the more opportunity there is for runs of heads or tails to occur, so you should expect to see more runs and you should expect them to be longer too. In fact, the more you flip the coin, the more likely you are to see any particular sequence of events occur, no matter how unlikely or extreme it may seem at the outset.

This is just another way of saying that time (flips) and volatility (runs) are two sides of the same coin.

Is it just me, or is the world getting crazier?

The relationship between time and volatility holds in all areas of life. The more time that goes by, the more opportunity there is for crazy stuff to happen and the crazier that stuff will be. When people remark that the world seems to be getting crazier with every passing year, they’re right; it is! The relationship may not hold exactly from one year to the next, but over time the trend is clear.

Eventually, there will be a volcanic eruption greater than Tambora. Eventually, there will be an earthquake more powerful than Valdavia. Eventually, there will be a meteor that is bigger than the one that killed the dinosaurs. Hopefully none of things will happen any time soon, but they definitely will happen, eventually.

This isn't restricted to the mathematical or natural world either. It encompasses all of human behaviour. Someone will break Flo-Jo's 100m world record. A book will sell more copies than the Harry Potter series. There will be a US president less popular than Donald Trump. Popular culture will reach new lows, or new highs, depending on your perspective.

What does any of this have to do with COVID-19?

The longer we keep the virus alive, the more opportunity we give it to do things, crazy things, bad things (for us). It will continue to mutate, and natural selection will eventually find a mutation that helps the virus to transmit faster and wider, and at a greater cost to its hosts. The B.1.1.7 (UK) and B.1.351 (South Africa) and P.1 (Brazil) strains are the most prominent demonstrations of this process, but they are neither the first nor the last that the virus will produce.

Is the virus airborne? Will it become more virulent? Can children suffer long-term health damage from COVID-19? Is reinfection possible? If the answers aren't yes already, then they will be soon enough. Just keep giving the virus time and opportunities to mutate, and all of these things will happen.

In fact, the SARS-COV-2 virus itself is a demonstration of the idea, just on a longer timeframe. Who know where it was or what it was doing, but at some point it jumped onto an animal and then into a human, mutating and evolving in the process. Variants of the H1N1 influenza virus caused both the 1918 pandemic and the 2009 Swine Flu outbreak, and many more in between. We will probably see another major H1N1 outbreak in our lifetimes. We'll see a SARS-COV-3 outbreak too. Whether they are more dangerous or cause more damage than their predecessors depends less on the viruses and more on our responses to them. Will we have learned our lessons by then?

If you manage your risks...

If it can happen, then it will happen, and you need to be prepared when it does. That is where risk management comes in.

Something that can happen is a risk. Whether that risk presents a threat to you or not, depends on what you do today, tomorrow, and until it eventually happens. If you prepare for the risk in advance, then the potential damage will be minimised or prevented entirely. If the risk is ignored, denied, or put on the long finger because it is unlikely to happen this week or next, then you risk finding yourself in a 2020-2022 scenario again.

We call it 'risk management' because the goal is to take care of the threat while it is still a risk i.e. before it happens. For the same reason, you buy insurance before you travel, you put your seatbelt on before you put the key in the ignition, you but your defences and reparations in place before the event happens, so that you are protected when it eventually does.

We should have had our pandemic defences in place long before COVID-19 came along. There were no end of warnings that went unheeded but, that is a conversation for another day. More immediately, we need to understand that the longer COVID-19 is allowed to circulate and multiply, the more dangerous it will become. Looking further out, we also need to recognise the need to develop a pandemic defence infrastructure and put it in place before the next virus arrives.