Study considers how a seemingly risky investment can reduce risk.

From the most naïve investors to the most sophisticated, people want the value of their investments to increase. Unfortunately, everyone—from that naïve investor on up to those who manage money professionally—knows that there’s no magic formula for maximizing return with the lowest possible risk. Along with financial advisors, finance scholars look at investment strategies, trying to detect associations that might guide investors toward a better risk-return portfolio.

Surprisingly, one potential investment that can actually help to reduce risk is a risky one—one that measures uncertainty in the market and the subject of a study by Robert Daigler, Knight Ridder Research Professor of Finance in the College of Business Administration.

“People watch the market go up and down—what we call ‘volatility’—but, until recently, they could not do much of anything other than watch,” he said. “Three years ago, a futures instrument was introduced on the VIX (volatility index). This instrument enables investors to buy and sell stock-market volatility.”

Questions immediately arise about such investment opportunities. Since most people do not like uncertainty in the market, why would they want to invest in it? How does one invest in something as intangible as a concept? And where would such an investment fit into a portfolio striving to reduce risk?

“One reason people will invest in something like volatility is that it gives them a chance to offset negative returns in the stock market rather than simply observe the market’s,” Daigler said. “Futures and options contracts on the VIX allow individuals to trade a concept such as volatility, even though the volatility is not a true asset as are stocks, bonds, and real estate. Meanwhile, institutions have been able to trade volatility in over-the-counter instruments called variance swaps for years.”

To tackle the issue of why a risky investment, which even bears a name that points to its uncertainty, should be included in a portfolio to reduce risk, Daigler and Laura Jaramillo Rossi (MSF ’04), then a student in the college’s Master of Science in Finance (MSF) program and taking Financial Risk Management, analyzed historical data on the VIX to see what patterns would emerge.

Research zeroes in on the relationship between the S&P 500 and the VIX.

“We know that, on average, when the S&P 500 goes up, the VIX goes down, and when the market goes down, the VIX goes up,” Daigler said. “So, since the two go in opposite directions, they at least partially offset each other. If the market goes down, the fact that the VIX goes up makes it a good instrument to compensate for stock losses—mitigating, for example, the consequences for investors when the NASDAQ lost more than 75 percent of its value between March, 2000, and the end of 2002.”

The article assumed that people put most of their money into the S&P 500 portfolio of stocks. The researchers then looked at what percentage of their funds should be allocated between the stocks and the VIX in order to minimize risk by applying the Markowitz Portfolio Theory to the data.

“Harry Markowitz won the Nobel Prize for economics in 1990 for the theory he published in 1952,” Daigler said. “The underlying idea of portfolio theory is that if you have a negative correlation between two assets, you can design the best combination to minimize risk. Our idea was to apply the portfolio theory concept and see what happened. What we found by analyzing the data is that the best combination for using VIX to minimize risk is 90 percent in stocks and 10 percent in the VIX.”

Titled “A Portfolio of Stocks and Volatility,” the study was published in The Journal of Investing, a leading practitioner journal in the finance field. Daigler is working with current and past graduate students on related research, including various aspects of the VIX futures contract, diversification with commodities, and the impact that the general public has on the volatility of futures markets.

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