In financial markets, few things are as predictive as volatility; it has been well documented that the best predictor of tomorrow’s or even next month’s volatility is today’s volatility.
The importance of this becomes evident when we consider how this fact can help keep portfolio risk levels constant throughout the investment horizon. If indeed today’s volatility predicts tomorrow’s volatility, and today’s volatility exceeds our predetermined risk levels then we can easily adjust our risk by reducing our position sizes dynamically.
We illustrate this concept in the chart below.

Source: Yahoo Finance, DarwinFunds.ca
To illustrate further, this graph highlights some of the major events leading to the credit crisis and the corresponding cash position required when using this basic approach. As we can see, large cash positions of up to 84 percent were necessary in order to keep daily volatility constant at our target of one percent.

Source: Yahoo Finance, DarwinFunds.ca
What is also obvious is that this type of risk management not only helped keep portfolio risk consistent but also aided quite substantially in providing better absolute and risk-adjusted returns over time.
To further illustrate the relationship between returns and volatility, we compare market compound returns during periods of high volatility versus periods of low volatility. In the bar graph below, we divide the volatility of the S&P 500 into quartiles from highest to lowest and assign them to their corresponding market return.

Source: Yahoo Finance, DarwinFunds.ca

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