The Economist published a Buttonwood column entitled "In Praise of Volatility" in its January 17, 2009, which complements nicely the danger of low volatility described in The New York Times's "Risk Mismanagement" (more on that here) - if you don't remember the article in the Times, the danger is that models fed numbers with low volatility will assume this state of low fluctuations will continue into the future and put insufficient amounts of cash in reserve, although periods of extreme calm often precede ferocious crashes.

The Buttonwood columnist briefly mentions the well-publicized Ponzi scheme orchestrated by Bernard Madoff ("Low volatility was a large part of Bernard Madoff's appeal"), before connecting volatility aversion with the way fund managers' performance is analyzed: since investors' preferences on the matter are so well-known, it is tempting to game the system by creating fake low volatility, for instance by (1) investing in illiquid assets (rarely re-valued, because rarely traded), (2) selecting small-gain strategies, which in the end tend to go wrong spectacularly, and wipe out the fund when they do (in other words, the fund has a stellar track record until just before it goes out of business, which bears a striking similarity with what happened to the dinosaurs at the end of the Cretaceous period), and (3) "resort[ing] to fraud when things go wrong", especially due to the pressure for companies to meet their quarterly forecasts.

The columnist argues that life is not linear, so people should make their peace with volatility ("Markets do not rise at a steady pace and business conditions do not allow for a smooth rise in profits.") It of course leaves out a big part of the story, as one would expect given the limited amount of words the column has on the page. Too many investors, starting during the heyday of the dot-com boom, have entered the market with their eyes on the ups without being able to stomach the downs. If their neighbors made a good return on their investments, or at least professed to make one, they wanted in too. That statement also applies to real estate, and people who did not have the means of becoming homeowners but did so anyway, fooled by the banks' happy reassurances until their mortgage rates adjusted.

Just like Bernard Madoff's investors, first-time homeowners and investors all longed to be part of the in-crowd. (A Bethlehem resident who lost millions in the scheme described the situation as follows: "We'd been on a waiting list for six months because he just didn't have room for new clients, and finally they accepted us. We felt like we were entering an exclusive fraternity. We felt lucky." [Morning Call, December 16, 2008])

The situation is about more than telling people that volatility is a part of life, or warning some who really are averse to losses that they shouldn't invest in high-return instruments, because high returns come with high risks these investors can't afford. In the country of self-made men, where stories abound of entrepreneurs retiring at 40, investing in the stockmarket or owning a house is a sign of status, and people will believe almost anything to hang on to their dreams - the rules have changed, the house bubble won't burst, the prices will just keep on increasing forever, etc.

An older article in The Economist raises the issue of learning the lesson too well: will people stop on investing because of the amounts they lost in the stock market? (When the golden egg runs out, December 4, 2008) The author argues that would be a mistake, using well-known arguments. I particularly liked the following sentences: "The problem is that investors do not regard financial assets as they do other goods; lower prices do not encourage them to buy more, but simply reduce their confidence. Past returns are the main determinant of flows into the stockmarket; investors buy when prices have gone up, not down."

In the end, we are just one big pendulum, swinging from one extreme to the next with unbridled enthusiasm. The problem isn't low volatility - it's the herd mentality that sets in when people don't understand what's going on and yet don't want to admit they don't have a clue, hiding behind a crowd in the hope no one will notice their ignorance. (If everyone is buying this stock, they must know something I don't, right?) A lot of good it did.