Nix the VIX

For many investors, the ups and downs of stock market volatility can be difficult. Source: AFP/ Getty Images.

The V word: Volatility. Even long-term growth investors get caught up in markets’ day-to-day movement—ignoring that long-term returns, not short-term gyrations, determine whether they reach their goals. As a result, it’s tempting for many to heed the alleged warning signs from one common (assumed) indicator of forthcoming volatility: the VIX. But in my view, long-term investors needn’t give it much thought.

Many investors might say the market is volatile if it moves up or down 1% or more throughout the trading day—and sweat the swings, fearing short-term dips mean an even worse immediate future looms. Sharp moves can be hard to stomach—even if sequential down and up moves are equal-sized, it’s basic human nature to feel the pain of those losses more acutely than the joy of gains. But framed properly, short-term wobbles and wiggles are just that—short term. What should matter more to investors with lengthy time horizons is what their portfolio does over a longer time frame—and over time, zigs and zags tend to even out.

Still, some hyper-focus on volatility, and seek ways to tame it—even if enduring quick drops doesn’t dampen long-term returns, avoiding them feels better. The “sleep at night factor.” Accordingly, some seek tools they think will help. One popular tool is the Market Volatility Index, or the VIX. Created by the Chicago Board Options Exchange in 1993, it uses options prices to forecast implied S&P 500 volatility over the subsequent 30 days. Options prices, the theory goes, are useful indicators because they’re partly determined by volatility—higher volatility of the underlying security makes the put or call option more valuable and vice versa. But by this logic, volatility determines options prices which determine ... volatility? A little confusing, to say the least.

Beyond the philosophical, a deeper look at the VIX suggests it isn’t a reliable timing tool. For one, it only measures 30 days forward, essentially encouraging very short-term timing moves—a perilous path. Not that there aren’t times when it’s appropriate to position your portfolio to avoid potential downside, such as forecasting a bear market. But a 30-day bear is a rather endangered species—there aren’t any historically. If you expect continued bull market over the mid to longer term, attempting to time the short-term volatility often carries significant costs—both trading and opportunity costs if your bet goes wrong.

Which could easily happen if the VIX is your primary guide. Even if you assume it correctly predicts forward-looking volatility (history shows it’s shaky), it’s still a poor predictor. The VIX spits out the absolute value of expected returns over the next 30 days. Or, rather, it spits out a number you have to annualize to get the final prediction. If the VIX reads 20, expected volatility over the next 30 days would be 5.77%—in either direction. And here lies an inherent flaw: The S&P could move up or down that much over the next month, leaving investors to decide which direction is most likely. Market timers using this stand a 50% chance of making the wrong call—and possibly missing upside. Now, consider: The person judging this coin flip is trying to avoid volatility—quite often due to emotion. How likely is a highly emotional person to gauge the correct direction of a tool dubbed the “fear index?” For example, say the VIX predicts the market will move up or down 4% and you’re rather pessimistic, so you think it will move down—but it moves up! (Stocks, after all, love defying expectations.) And not just up 4%, it moves up 7%. Not only did you make the wrong call, you missed some pretty big upside.

It might be tempting to chalk this up as a simple missed opportunity and call it a day—missed opportunities are an unfortunate fact of life, and at least you didn’t lose anything! (Err ... accept those trading costs.) But if you need at least roughly market-like returns over time to reach your goals, that’s a fallacy. If you miss a big run-up, you’re that much further from your goals—just as far as you’d have been if you rode stocks down the same amount. Except, if you rode stocks down, you’d likely be poised to capture the quick recovery typical after such moves. If you’re on the sidelines due to VIX fear, you have to get back in to advance—not always a move that’s easy on the nerves.

On the flipside, a common adage about the VIX holds, “When the VIX is high, it’s time to buy.” It assumes a high VIX means high fear, and the market does the opposite of what the crowd expects—rampant fear is bullish. But volatility doesn’t indicate fear or market movement in either direction—it’s just ... volatility. It’s just there. And just as I’d advise against using the VIX to miss downside, the same can be said for trying to forecast an upswing. Besides, who’s to say what’s actually “high?” 30? 40? 50? The VIX peaked above 80 in 2008—months before the March 9, 2009 bottom.

But those who use the VIX, or anything else for that matter, to forecast and attempt to time short-term volatility often forget volatility is an important part of long-term equity appreciation—it’s actually how stocks appreciate. After all, stocks can’t move up if they don’t move at all. Many investors associate volatility with quick, and especially downward, movement. Though that’s not necessarily wrong, it’s only half right—upside volatility is volatility, too! The V-word simply means movement up or down. Over long periods of time, this movement adds to portfolio returns—returns that ultimately help investors reach their long-term financial goals and objectives.