Volatility targeting
Volatility targeting holds risk constant instead of capital: invest less when markets are turbulent, more when they are calm.
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The rule
exposure = target volatility / realised volatilityWith a 15% target and realised volatility of 30%, exposure is 0.5x. With realised volatility of 10%, exposure would be 1.5x, usually capped by a leverage limit.
Why it can help
Volatility clusters: turbulent weeks tend to follow turbulent weeks. Moreira and Muir (2017) found that volatility-managed portfolios improved Sharpe ratios for several equity factors.
Limits
Realised volatility is backward-looking. A crash from a calm market, such as October 1987, hits at full exposure. Frequent resizing also costs money, so most implementations rebalance weekly or monthly with buffers.
Practice
Three quick tasks. Pick an answer to check it, or open the answer below each task.
Target volatility 12%, realised volatility 24%. What exposure?
Show answer
0.5x. 12 / 24 = 0.5.
Target 15%, realised 10%, leverage cap 1.25x. What exposure?
Show answer
1.25x. The rule asks for 1.5x but the cap holds it at 1.25x.
When does volatility targeting fail to protect?
Show answer
In a sudden crash from a calm market. Exposure is highest just before the shock, because realised volatility was low.
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