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The Volatility Index-Much Ado about Nothing

Written by Dan Solin on July 13, 2010 in Retirement  |   5 comments

You have no doubt been reading a lot about the volatility index lately. Before I tell you why I believe it is irrelevant, let me first tell you what it is. The Chicago Board Options Exchange established a volatility index (VIX). The VIX is not…

Volatility index predict wall street marketsYou have no doubt been reading a lot about the volatility index lately. Before I tell you why I believe it is irrelevant, let me first tell you what it is.

The Chicago Board Options Exchange established a volatility index (VIX). The VIX is not a measure of how volatile the markets have been. It is a reflection of how volatile investors predict the markets will be in the short term. An increase in the VIX option price means investors expect market volatility to be high. This is typically interpreted as a sign that investors are fearful of future market conditions. That’s why this index is often called the “fear index.” When it’s lower, investors supposedly feel more comfortable.

Investors are paying attention to VIX prices these days because the markets are very turbulent. Some investors are buying or selling VIX contracts (or purchasing shares in an exchange traded fund (ETF) that tracks the VIX’s performance) in an effort to profit from what they perceive as a trend of continued volatility. Others use the VIX to guide their investment decisions. Both uses are ill-advised.

Buying or selling VIX contracts is simply speculation. You may be right or wrong. Tomorrow’s news moves markets. No one knows what that news will be. When you “buy the VIX”, you’re gambling with your investment capital. When you speculate, your expected return is zero (or less, when you consider expenses).

Using the VIX to guide investment decisions is another bad idea. All we know about the equity markets is that, historically, they increase in value over time. In the short term, the equity markets are volatile-in an unpredictable manner and to varying degrees. Short-term volatility has very little discernable impact on long-term returns.

Investors (as contrasted with speculators) invest for the long term. They are not concerned with short-term volatility.

So how do you deal with stomach-churning short-term volatility?

1. Understand that some segments of the markets are very volatile. Every portfolio should have a mix of risky investments and more conservative ones. The risky investments (like small and value stocks) will have greater short-term volatility-and higher long-term returns-than more conservative investments.

2. Focus on long-term data. Instead of looking at short-term volatility, consider the amount of time you can hold on to your stock portfolio without selling 20 percent or more of it. If you have a time horizon of less than five years, you should have no exposure to the stock markets. If you have a time horizon of twelve years or more, you can be heavily invested in stocks. The long-term data indicates an extremely high statistical likelihood of meaningful annualized returns for investors who can hold on through the periods of short-term volatility.

Rather than fearing short-term volatility, you should understand and embrace it. It’s part of investing. In fact, when the markets are bad, the long-term prospects for stocks and bonds are better.

Ignore the VIX and all the talking heads on television carrying on about the significance of this volatility index. It’s just another way to panic you into making short-term decisions harmful to your long-term financial health.

Dan Solin is a Senior Vice-President of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read and The Smartest 401(k) Book You’ll Ever Read. His latest book is The Smartest Retirement Book You’ll Ever Read.

Follow Dan Solin on Twitter.

Read More:

Five Simple Rules For Protecting Your Retirement Savings

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Creating Your Own Best Retirement Plan

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5 comments

  1. Ron X says:

    It is always interesting to see how two people can talk with some authority on the same subject and reach entirely different conclusions. Since stock market moves can be more a matter of psychology than economics, why give the VIX a shot. A chart of the VIX over the last five years shows a very strong inverse correlation with S&P500. The investment tactic is "when the VIX is high you buy" and “when the VIX is low, you go” (sell).

    You stated "… the ‘fear index.’ When it's lower, investors supposedly feel more comfortable." As you should know, the VIX is a simple calculation using actual market transactions so it is a direct representation of those whom are currently participating in the market. It may be the best possible indicator of either their complacency or fear.

    These charts of VIX compared to SPY are readily available via finance.yahoo.com

    See:
    http://finance.yahoo.com/echarts?s=^VIX#chart3:symbol=^vix;range=5y;compare=^gspc;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

  2. Jennifer A. Freeman says:

    Hi Ron,
    Thanks so much for commenting.
    I'm an editor for the Equifax Personal Finance Blog.
    I think Dan's point is that using the VIX to guide investment decisions isn't a great idea. It's hard to tell from your comment whether you agree or disagree. Care to elaborate?

    Jennifer

  3. Ron X says:

    Jennifer and Dan,

    Well, the main purpose of my post was to get people to look at the chart and see for themselves what the actual past trend has been. Hopefully, the more serious equifax bloggers will.

    Of course, an "inverse correlation" just means as one value (S&P500) goes up, another one goes down (VIX), and vice versa.

    As I said, the investment tactic is "when the VIX is high you buy" and “when the VIX is low, you go” (sell). The chart is showing me that this approach certainly would not be profitable for trading but would be for investing over a 3 to 18 month period. This has been my experience as well.

    Conclusion: The VIX is one of several important variables to examine particularly at times of when one wants to determine whether the stock market (SPX) is in process of bottoming or topping.

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