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When markets get scary, panicking is smart: Yale profs

When volatility rises, is panicking wise?

It's classic investment advice: When markets get volatile, the worst thing you can do is panic; instead, take a deep breath and stay fully invested.

But according to two Yale researchers, that advice could be completely wrong.

"In volatile markets, there's a lot of additional risk that investors are exposed to, and if they're not being adequately compensated for that risk, then the right thing to do, actually, is to exit," Tyler Muir of the Yale School of Management said Monday on CNBC's "Trading Nation."

"That's what we find in the data," he added.

Muir and Yale assistant professor of finance Alan Moreira recently published a paper to this effect, entitled "Volatility Managed Portfolios." What they found is that contrary to the popular wisdom that the potential for higher returns makes up for higher risk in volatile markets, those who avoid investing in volatile times actually enjoy superior risk-adjusted returns.

The advice that when everything is crazy, just sit tight is based on the assumption that everything is properly priced in — but it turns out that the inverse relationship between return and risk is not static, Muir and Moreira told CNBC in a three-way phone interview.

"Our point is that if returns are not predictable by volatility," then one should vary one's investment according to volatility since this will allow the investor to "reduce your risk without forgoing returns," Moreira said.

To illustrate their point, Moreira and Muir present the following chart. The researchers compare the value of a dollar passively invested in the market to the value of a dollar invested according to their volatility-timing strategy, which diminishes market exposure in volatile times and increases it in calm times. On the whole, that makes one's average market exposure 100 percent, just like in the buy-and-hold strategy.

The obvious implication is that volatility-timing can generate outperformance.

Interestingly, this isn't just a strategy for hedge funds and other large investors to consider. Muir said that since the scheme simply involves consulting a standard measure of volatility and trading once a month, an average investor can pursue such a strategy for oneself.

The academics slice and dice market data from the U.S. and around the globe in order to marshal evidence for their overarching point, but not everyone is quite convinced.

"It's certainly very clever," as well as "provocative," commented economist John Cochrane, whose work is cited several times in Moriera and Muir's paper.

Yet in an email to CNBC, Cochrane adds that he'd "ask lots of questions before I put money in. Does it work in real time, are there big drawdowns … does the graph really show steady gains or are the gains just in a few time periods, can you implement it in real time, and so forth."

In addition, "there is the nagging question, if you're buying, who is selling? We can't all sell, all the children can't be above average, and so forth. The average investor holds the market," the economist wrote.

That is to say, the implication would be that those who do the opposite of Moreira and Muir's advice and buy in periods of high volatility are getting ripped off. If so, that would lead us to wonder why people would keep doing that.

Max Wolff, chief economist with Manhattan Venture Partners, adds that by using volatility and returns data to poke a hole in a somewhat simplistic assumption about how those very same data series ought to interact, Moriera and Muir have "set themselves in a low-bar scenario."

Still, the idea that investors fail to receive enough returns in volatile times to make up for the risk they take on is a provocative one that may prove to have some merit and is likely deserving of further study.

And if nothing else, it should provide some comfort for those many investors who have panicked and sold at levels that turned out to be — in hindsight — epic buying opportunities.