The only thing to fear about volatility is fear itself

Dave S. Gilreath: ©Sheaff Brock Investment Advisors

The word “volatility” can apply to just about anything that’s changeable — from blood pressure to rainfall amounts to a person’s temperament.

The higher the volatility, the more rapid and extreme the fluctuations.

Regarding the stock market, high volatility means that major indices and the stocks they comprise are moving up and down far more frequently and extremely than usual. While a boon to pros who know how to profit from it, high market volatility is vexing for most individual investors.

So, the ordinary conception of market volatility is negative — that it’s tantamount to risk. Yet legendary investor Warren Buffett has steadfastly pointed out that this notion, widely taught at business schools, is dead wrong. The Oracle of Omaha maintains that the real risk from volatility is that it prompts the uninformed to do risky things.

While most pros know better, individual investors acting on this misperception of risk often sell shares when they shouldn’t, creating a self-fulfilling prophesy.

Fear levels that drive such missteps are stoked by financial media’s reporting on volatility as though it were an Ebola outbreak.

Like most things in finance, volatility is quantified in an index. The CBOE (Chicago Board of Options Exchange) volatility index, aka the VIX, measures market volatility on a daily basis. When the market is highly volatile, there’s usually a lot of fear, so the VIX has a rather ominous nickname: the fear index.

The VIX was launched in 1990 to measure the implied volatility of the S&P 500 index of large-company stocks, based on the pricing of near-term options on that index. The VIX rises when investors seek the protection of options, a form of portfolio insurance, during times of market uncertainty.

Since its inception, the VIX has averaged 19.5 and tends to revert toward this level over time. But it can remain well above or below that level for extended periods. When investor anxiety increases, demand for the downside protection afforded by options rises, and this pushes the VIX higher.

Shifts in volatility levels usually tend to be gradual. As stocks begin to sell off more rapidly, the VIX typically rises. A market catalyst, such as an economic shock or policy surprise, can trigger a sharper decline in stocks and a rapid spike in the VIX, often pushing it above 30.

Because of the gyrations over tariffs, the market has recently been quite herky-jerky. On April 8, the VIX closed the day at 52.33 — the highest level since March 16, 2020, at the onset of the pandemic.

Sucker bait

Much high-volatility trading isn’t the direct work of humans. Computerized trading, common among big institutional investors, is increasingly driven by sets of conditional instructions — algorithms — that read news headlines and trade accordingly.

And when these upward trades prompt enough individual investors to pile in at rising prices, these same algorithms sell stocks for a profit. During periods of high volatility, there is sucker bait aplenty.

Historically, only 8.3% of trading days have registered a VIX above 30, and about half of those days have come during major economic downturns, such as those of 2000–2002, 2008–2009 and 2020.

Since 1990, there have been 31 instances when the VIX climbed above 30 for the first time in 30 or more days, reflecting rising fear.

Such spikes usually occur after the S&P 500 has already declined nearly 15% and the market is roughly halfway through a longer-term drawdown.

Stock returns following periods of high volatility have usually been strong, except in long bear markets, such as those following the tech bubble (2000–2002) and the Global Financial Crisis (2007–2009).

Though market declines are bad news for most investors, they often lay the foundation for the next rally.

Sharp rises in the VIX are unsettling, but they’re often interpreted by contrarian investors as a bullish signal of market bottom — a time to buy. As Buffett famously said: “Be fearful when others are greedy and be greedy when others are fearful.”

Passing on the roller coaster

Investors aware of this historical pattern often seek to take advantage of fear with a strategy focused on exploiting periods of high volatility.

At VIX peaks, they nibble on particularly volatile stock sectors by buying a few shares to establish a position. Then, as the VIX trends downward, they buy far more shares at increasing yet still-discounted prices. Thus, they’re in a position to sell for gains after diminishing fear lowers the VIX and prices rise.

This strategy may be a bit too technical for most individual investors, and perhaps a bit dicey for them to execute.

Yet, those who pass on this shouldn’t have any regrets because the goal for them is more commonly one of not getting hurt by volatility.

And as Buffett says, the way to avoid damage from it is to keep fear of it from making them do something stupid. That means doing what’s often both the safest and easier thing to do in investing: nothing at all. “Lethargybordering on sloth remains the cornerstone of our investment style,” says Buffett, who in early May announced his retirement from perhaps the most successful investing career ever.

Though Buffett doubtless has bought during volatility-induced price dips, many individuals should probably borrow a page from his books and recognize that less is more.

Regarding volatility, most are better off just watching the market roller coaster from outside the ride’s fence and never buying a ticket.

In avoiding potentially damaging short-term trading, they execute Buffett’s predominant strategy of investing for the long term, letting short-term effects on their portfolios average out over time.

Dave Sheaff Gilreath, CFP,^® is a founder and chief investment officer of Sheaff Brock Investment Advisors, a firm serving individual investors, and Innovative Portfolios,^® an institutional money management firm. Based in Indianapolis, the firms were managing assets of about $1.4 billion, as of March 31.
Investments mentioned in this article may be held by those affiliates,Innovative Portfolios’ ETFs or related persons.