EFF: There has always been lots of variation through time in market volatility, and volatility tends to be mean-reverting. (See our white paper, "How Unusual Was the Stock Market of 2008?") If investors can't tolerate periods of high volatility in stocks, this should affect their decisions about stocks, whether or not volatility is currently high.
KRF: It is certainly true that stock market volatility is higher now than it was two or three years ago. At the end of 2006, the VIX, a measure of the annual stock market volatility implied by S&P 500 option prices, was below 12%.
The VIX reached a high of over 80% in October and November 2008, but it has fallen to about 25% by July 2009. For perspective, the annualized volatility of monthly market returns from 1926 through June 2009 is about 20%. This means the current market volatility implied by option prices is closer to the long run average than the volatility investors experienced before the current financial crisis. Given the volatility of market volatility, it seems strange to conclude that we have moved to a permanently higher level of volatility.
What are the implications of the higher volatility we are experiencing now? We should start with two fundamental facts. First, the value-weight average of all investors' portfolios must be the market portfolio. Since stocks have fallen a lot more than bonds over the last two years, stocks are now a smaller fraction of the market portfolio. On average, investors have already reduced their allocation to equity. Second, for every seller there must be a buyer. We can't all sell stock. (As an aside, these two facts imply that - unless we drag market prices back to their former values - we cannot all rebalance back to the allocations we had two years ago.)
So, should you reduce your allocation to equity because volatility is higher now than it was two years ago? Again, the market has already reduced your allocation for you. There is no reason to go further unless (a) you are more pessimistic about the relative performance of stocks than the value-weight average of all other investors, (b) your forecast of volatility is higher than the forecast of other investors, or (c) the higher volatility is more painful to you than to other investors. Most of us are fooling ourselves if we put much weight on (a) or (b). It is unlikely we have insights that are not in market prices already. For some of us, however, the turmoil of the last two years has revealed that our tolerance for risk is lower than we thought. Those who have discovered they are more risk averse than they expected probably should sell some of their remaining equity. But this should be a permanent adjustment. The equity market always has been and will continue to be a scary place.
Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.