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The Volatility of Volatility: What You Need to Know About the VIX

Volatility is often perceived by investors as a negative. No one likes to think about the likelihood that their stock prices will move in the wrong direction. And a high level of volatility can act as an impediment to successful investing, especially when it causes people to make irrational portfolio decisions based on short-term events. Consider the investors who sold their stocks and went to cash during 2008, assuming that the declining markets would remain depressed for a very long time. Investors who didn't participate in the stock market between 2009 and 2014 missed out on the S&P 500 more than doubling in value over those 4 years.

That’s why it’s important to understand what volatility means in the financial markets. Simply put, volatility refers to how much, and how quickly, the price of a security is expected to change. The index that tracks the volatility of the S&P 500 is commonly known as the VIX.  The VIX bases its pricing off the implied volatility of S&P 500 index options viewed over the upcoming 30-day period.  Sometimes investors and market commentators refer to the VIX as a "fear index" because it can indicate an expectation of uncertainty, reflected through the pricing of options. But some economists would argue that characterizing the VIX as a fear gauge may be an inaccurate or unfair description of what the VIX index is reflecting.

Market Volatility and Long-Term Investing

In theory, increased market volatility can present a buying opportunity for investors. Downside volatility, i.e., a decrease in prices, provides better entry points for putting new cash to work in the market. If the stock market were to increase gradually each trading day for a full year, you would never have a day in which you were buying stock at a lower price than the day before.  However, market volatility may provide you with many entry points over the course of a year in which you can purchase securities at a lower price than the day before. In practice, of course, it’s impossible to see into the future, and no one can know for sure when prices have bottomed out. That’s why this approach works best for people who invest consistently in a diversified portfolio and maintain a long time horizon in which to purchase and hold their investments. Assuming stock prices move up over long periods of time, which they have since the Great Depression, these opportunities to buy assets at a lower price are very valuable.[1]

On a related note, volatility can present opportunities for investors looking to exit the market as well.  Perhaps an investor nearing retirement is holding a security that tracks an index that has risen rapidly over the past year. If the index averaged an 8% return for a few years but then returned 30% in a single year, surpassing the investor's expectations, that could present an opportunity to exit the position. The higher return doesn't necessarily mean the index is overvalued, but the upside volatility could help an investor to meet his investment goals earlier than expected.

Volatility Has Declined in Recent Years

With this concept in mind, patient investors might be interested to learn that, since the global financial crisis, volatility has declined considerably.[2] While it seems to have picked up a bit in recent months, the VIX index is still nowhere near where it traded in 2008-2010. So what can we conclude from this sharp decline in the VIX? Unfortunately not all that much. A lower VIX, at face value, indicates a lower expectation of a market correction as measured by the current pricing of S&P 500 options. That doesn't mean there won't be a correction, it just means the market isn't heavily pricing one in.  We mentioned earlier that the VIX is sometimes referred to as a "fear index" where low levels may be indicating complacency and high levels may be a warning or problems to come. Despite that characterization, some market commentators still maintain that the VIX follows the market and not the other way around, therefore VIX pricing is only telling you what you read into it.

How to Invest with Volatility in Mind

So how should you invest with respect to an increase or decrease in market volatility? The answer to that may very well be to not make any changes at all and to continue following an investment strategy tailored to your own specific needs and objectives. If you are using a routine, systematic investing process such as monthly or bi-weekly deposits, then the level of volatility doesn't really matter, except to help you accumulate assets at lower average prices, as discussed above. The downside might come into play for those at or nearing their asset distribution phase, in which case doing a full review of portfolio holdings may be useful.

Some investors may fall into that emotional trap of trying to time the market around increasing or decreasing volatility. But savvy investors are aware of the potentially negative impact that trying to time the market can have on a portfolio, especially one with long-term objectives. If history is our only real guide to the future, then volatility is a normal part of the market, and one which can be helpful to its participants.

[1] The S&P 500 Index has not had a 10-year stretch in which the index has moved lower since 1937.

[2] On Jan 1st, 2009, the VIX Index measured 39.58. On Jan 1st, 2015, the VIX Index measured 17.76.

 

Behavioral Finance Long-term investing Market Timing Stock Investing Volatility

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