Two-faced volatility: risk and opportunity
Investors face a multitude of options when it comes to allocating their funds across various asset classes. From the relatively low-risk government bonds to the higher-risk mid-cap stocks, each asset class offers its own unique characteristics. In this study, we seek to identify the asset class that offers the best potential return opportunities for traders and investors with a short-term investment horizon.
We first examine the volatility profiles of different asset classes using the average standard deviation of daily, weekly, monthly, and quarterly returns.
Figure 1: Breakdown of volatility for examined asset classes
In terms of potential return opportunities, we need assets that could potentially move much, i.e. be volatile. According to Figure 1, our target playground is Mid and Large Cap Stocks.
In addition, we analyze the statistical distribution of returns (DoR) for each target asset, with a focus on its skewness and kurtosis. To test our argument about potential opportunities with the Mid Cap Stocks, let’s compare the DoR of the S&P 500 index with that of a mid-cap stock under the BILL ticker (Bill Holdings Inc).
Figure 2: S&P 500 DoR for weekly returns, 2007-2022
Figure 3: BILL stock DoR for weekly returns, 2007-2022
As you may see, the distribution of S&P 500 historical returns demonstrates a more centralized figure and in terms of potential returns, it is restricted by its low volatility. On the opposite, the distribution for a mid-cap stock BILL is much wider with thick tails and it hypothetically may offer a higher potential return compared to the S&P 500 index over a short-term investment horizon of up to three months, all things being equal. However, it is important to note that this higher potential return comes with a higher level of risk. We assume that traders and investors have a thorough understanding of the risks involved and are conducting in-depth research before executing trades.
In addition to historical DoR, we recommend incorporating future implied volatility by the options market when making investment decisions. This can provide a more comprehensive view of potential risks and returns.
Investors looking for short-term potential returns should consider the risk profiles and statistical distribution of returns when choosing an asset class. While higher potential returns may come with higher risks, a thorough understanding of these risks can help traders and investors make informed investment decisions.
