Contrary to popular belief, high volatility is not a terroristic threat to investors. Rather, it is a natural part of the stock market.
High volatility is widely viewed as the Grim Reaper of stock returns, but nothing could be further from the truth.
This misconception underlies incorrect assumptions about the volatility index (VIX), a useful tool that ratings-hungry broadcasters and click-craving websites like to call the fear index.
Individual investors have been conditioned to believe that high readings in this index signal the dreaded reaper’s approaching footfalls with seismograph-like reliability. Not only do we know that doom is approaching, but we also know when it is arriving.
Of course, with such sensationalistic reports, financial media get the kind of rapt attention that only scared audiences can give. “The fear index is up,” talking heads intone, giving people the willies.
But investors should not be scared. They would be glad if they understood volatility and the VIX. Yet, because many do not, reports that the index is rising are considered bad news — and choice media fodder.
Contrary to popular belief, high volatility is not a terroristic threat to investors. Rather, it is a natural part of the stock market. Nor is the VIX a measure of fear; it is a gauge that can be used for gain.
The VIX measures the projected speed of up and down stock price movements. It reflects changes in levels of option premiums — the current market price of option contracts, which are agreements for the prospective sale or purchase of stocks for a set price within set time periods.
The index was created by the Chicago Board Options Exchange in the 1990s to anticipate volatility as indicated by the near-term (within 30 days) expiration of options on the S&P 500. The VIX is not an opinion. Instead, it is a formulaic and mechanical 30-day projection of stock price volatility.
Although some view the VIX as a measure of investor sentiment, there is no factual basis for the notion that the VIX turns on fear, nor any reason to believe that fear can be inferred from high VIX readings. Investors (primarily institutional investors) trade options to make money by anticipating stock price changes within set ranges. The index measures changes in price expectations, not fear.
Many people think that when the VIX is high they should reduce equity exposure, but they have things reversed: a high VIX signals opportunity. High VIX readings signal when you might want to buy stocks, not sell them, because these high readings are usually followed by good market returns in ensuing months. If you buy when the VIX rises above 30, then over the next six to 12 months the odds are high that you will have gains.
My firm recently did a study on the market’s behavior in the nearly 8,100 trading days that the VIX has existed. The average level has historically been 19.5. On nearly 700 days, it has been above 30. Six months after those 30-plus readings, the average price of stocks in the S&P 500 increased 85% of the time, and the index’s average return was 13.4%. And 12 months after a VIX of 30 or higher, the index gained in price 90% of the time, with an average return of 23.4%.
In October 2021, the VIX was around 15. If you held the popular misconception about the index, saying ‘the water’s calm so let’s jump in,’ you wouldn’t have done well on those purchases. At that time the S&P 500 was at 4,600. In late March, it was at 4,500.
But if you had invested in late January 2021, the last over-six-month-ago time the VIX was over 30, the S&P 500 had dropped to 3,800 from fears about the COVID-19 Delta variant, and the VIX popped to 37. By late July 2021 (six months later), the S&P 500 was at 4,400 was up 17.4%, like 85% of periods after previous VIX spikes.
So much for the perils of high volatility. For those who understand its consequences, a high VIX is an opportunity to position for growth. Instead of the fear index, it should be called the opportunity index.
Volatility in the market is as natural as wind in Earth’s atmosphere. If there is air, there will be wind, and if stock prices are subject to change (which will be forever), we will have volatility. Stock prices do not go up or down in smooth, even patterns. Instead, these lines on charts are always jagged to some degree.
Individual investors seeking to profit from these fluctuations directly by trading options have long faced the obstacle that this is a highly complex undertaking best left to pros (i.e., don’t try this at home). But now, a growing array of exchange-traded funds is making options strategies highly accessible to individuals, enabling them to effectively hedge risk, produce income or both without the complexities and high risk of investing in options directly.
Though there is nothing inherently bad about volatility, it can pose risk for some investors from a financial planning standpoint. If you are forced to sell stocks at the wrong time to meet cash needs, volatility could mean that you take losses instead of gains. This is only a problem for investors who have too much invested in stocks and not enough in less volatile assets that they could liquidate instead.
But for investors who have diversified portfolios with different asset classes, have planned prudently to meet anticipated needs for cash and maintain an emergency fund for the unexpected, volatility is no big deal. It is just market wind blowing.
David S. Gilreath, CFP, is a 40-year veteran of the financial services industry. He is a partner and chief investment officer of Sheaff Brock Investment Advisors LLC, a portfolio management company for individual investors, and Innovative Portfolios LLC, an institutional money management firm. Based in Indianapolis, the firms managed nearly $1.4 billion in assets nationwide.