Thursday, October 3, 2019

The current disconnect between volatility and uncertainty is large

Volatility, risk, and uncertainty are words often used interchangeably so that they sometimes lose meaning. Volatility is a statistical concept but does not capture the future unknown. Risk is more than volatility because the focus is on the chance for pain or negative consequences. Volatility may or may not be risky if measured correctly. Uncertainty can be both positive and negative. 

It is always good to go back to the first principles of Frank H. Knight who established the economic definition of the terms in his landmark book, Risk, Uncertainty, and Profit (1921): risk is present when future events occur with measurable probability while uncertainty is present when the likelihood of future events is indefinite or incalculable

There currently is a disconnect between volatility and uncertainty. Pre-2013, an increase in uncertainty caused greater spikes in volatility. Up until 2016, volatility and uncertainty moved in tandem. The last two years have seen a spike in uncertainty but no corresponding increase in volatility. The uncertainty has not translated into more dispersion of returns. Of course, uncertainty could mean revert, but a more likely scenario is that we will see increases in risky asset volatility.

The Economic Policy Uncertainty Website ( shows a link between uncertainty, economic activity, and stock volatility. Policy uncertainty is measured by dispersion in economist forecasts, changes in regulation and uncertainty measures in newspapers.

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