Don’t Make Investing Decisions Based on the VIX

Think you know what the VIX signals? Do you sell equities when the VIX is high and buy when the VIX is low? Or sell equities when the VIX is low and buy when it’s high? Well, both of those investment strategies are flawed.

Background

Referred to by the press as the “investor fear index,” the VIX is technically the ticker symbol for the Chicago Board Options Exchange Volatility Index, which shows the market's expected volatility. First introduced 25 years ago, the VIX has evolved and today it is a widely referenced measure of market risk – on a forward basis.

Calculated daily, the VIX uses the price of options on the S&P 500 and estimates how volatile those options will be between the current date and the option’s expiration date.

In Real Terms

Although it’s usually not referred to in percentage terms, technically the VIX should be because it represents an expected range of movement of the S&P 500 Index at a “confidence level” of 68% – which is one standard deviation of the normal probability curve.

Here is an example: let’s say the VIX is quoted at 15. This represents an expected annualized change in the S&P 500 Index of plus or minus 15% – with a 68% probability of being true. In other words, the VIX is predicting with 68% probability that the market will move within a 30% range (plus or minus 15%).

Let’s say the VIX is quoted at 30. This represents an expected annualized change in the S&P 500 Index of 30% - up or down – with a 68% probability of being true.

Remember, volatility is both on the upside and downside.

Selling/Buying When the VIX is High?

Some investors just ride it out when the VIX spikes, as it did in late January and early February, along with the first 10% market correction in years. Other investors take to heart this “fear index” description and actually increase their equity exposure when the VIX spikes and decrease their equity exposure when the VIX declines. And other investors do just the opposite.

But according to a study conducted by Tyler Muir and Alan Moreira, finance professors at UCLA and the University of Rochester, the stock market’s average return following high VIX readings is not statistically different than it is following low readings.

Muir further went on to say that investors miss this point because they myopically focus on the strong stock market performances that have occurred when the VIX was particularly high. But, he said, some of the lowest stock market returns have come after high VIX readings.

So, instead of considering the VIX a “fear index,” consider it to be a sign letting us know that the road ahead will be a bit bumpier.

Here is What We Should Discuss

February was the market's worst month in two years, with an estimated $5 trillion of market value wiped out. Why? Because of volatility? Or for other reasons?

In very simple terms, February’s selloff was driven by a lot of factors: a faster than expected rise in real rates chief among them. But remember, some worry is to be expected because the second longest bull market run in history – which started almost 9 years ago this month – will not go on forever.

But before you decide to reduce or increase your exposure to equities, call me to discuss.

Distributed by Financial Media Exchange.