Understanding Volatile Markets
by Dr. Invest
Many of you who have followed this blog understand that my approach is to identify the best time to invest into the market and the optimal time to get out of the market. This strategy frowned on by traditional finanical advisors and called "timing the market".
There is nothing wrong with long-term investments and your portfolio should contain them, but if you are going to invest in securities, you will need to understand some basic ideas. "Timing the Market" is generally directed at the effort of judging market lows and highs and buying and selling at the right time. This is done by "day traders", by "swing traders", and by "financial advisors". Financial advisors call this "balancing one's portfolio". Are you seeing the humor in the symantics of "timing the market"? The financial advisor recommends the instruments for you to invest in and get's his fee for managing your funds, his fee for selling you the product, likely he gets a percentage of the management fees for the product he sold you, and a fee when you sell the product he recommended. (see front load and end load) So whether you use "portfolio balancing" or "timing the market" really doesn't matter much. If a financial advisor is going to recommend "rebalancing your portfolio" you need to understand that "rebalancing a portfolio" shouldn't take place after your portfolio has lost 30%.
FOLLOWING THE VIX
So here is the tool you need to better judge the trend of the market. It is called the VIX. Here are some important points as shared by Greg Forsythe at the Schwab Research Center.
Key Points
- Based on S&P 500 option prices, the VIX is a measure of expected market volatility.
- Learn about distinct patterns among various market indexes, depending on whether the VIX was high or low.
- Action steps: Using VIX in your stock strategy.
Measuring Stock Market Volatility
Market volatility measures recent price changes for broad indexes like the S&P 500®. But while actual volatility tells you what's already happened, investors must look ahead, so what they need is a way to gauge potential future volatility.
Fortunately, the Chicago Board Options Exchange (CBOE) provides a convenient tool: the Volatility Index, or VIX. Based on S&P 500 option prices, the VIX is a measure of expected market volatility.
VIX History
First, let's take a look at how the VIX has behaved in the past. The chart below shows that it's generally ranged between 10 and 30 during the past 20 years, occasionally surging higher.
Because the VIX usually rises when the market falls and spikes during times of market distress, it's often called the "fear index." However, the VIX is really an uncertainty index, reflecting actual prices paid and demanded by bullish and bearish options traders.
Volatility Tends to Persist
Wouldn't it be great to know when the stock market was in a high- or low-volatility period, and adjust your equity strategy accordingly? The challenge comes in predicting volatilty persistence or shifts with enough accuracy to profitably act upon your forecast.
The chart shows two periods when the VIX was generally below its long-term average and two where it was generally above the average.
We found that when the VIX was above 20, 78% of the time it remained above 20 three months later. When it was below 20, 85% of the time it remained below 20 three months later. So the VIX has historically tended to remain high or low for extended periods.
Stock Performance During High or Low Volatility
So if the VIX tends to rise as the stock market falls, what happens to the market after the VIX moves above or below its long-term average? Our research found distinct patterns among various market indexes, depending on whether the VIX was high or low.
- Large- and small-cap stocks1 generally provided higher returns (about 2.6% each) the quarter after the VIX fell below 20 versus the quarter after it rose above 20 (1.5% and 2.4%, respectively).
- Large- and small-cap returns were almost 50% less volatile in periods after the VIX fell below 20 compared to after it rose above 20. In other words, the VIX has predicted market volatility well.
- Value stocks significantly outperformed growth stocks (3.1% large-cap value versus 2.1% large-cap growth and 3.3% small-cap value versus 1.9% small-cap growth) in periods after the VIX slipped below 20. Large-cap growth outperformed large-cap value (1.7% versus 1.1%) in periods after the VIX rose above 20.
Our findings suggest that investors can benefit from keeping an eye on the VIX (keeping in mind there's no guarantee future patterns will duplicate the past).
For example:
- If you're a buy-and-hold investor, you can use the VIX to help decide when to rebalance. For example, if your portfolio is overweighted in stocks and the VIX is above 20, consider selling back to your target stock allocation. When the VIX is high, the market is usually riskier and provides below-average returns.
- When the VIX is low, you may want to overweight large-cap and/or value stocks within your equity allocation. When the VIX is high, you may wish to underweight stocks overall, but overweight small-cap or growth stocks within your equity allocation.
- If you buy individual stocks, you don't need to vary your strategy as much in response to VIX levels, but you should expect less consistent performance when the VIX is high. When it's low, using value and momentum selection criteria may help performance. Schwab Equity Ratings, our tool to help you find individual stocks, has historically performed similarly when the VIX is low or high.
CONCLUSION
As of August 21st of 2011, the VIX sets at 42.67, not a good number for stocks. The market is not static but dynamic. Securities must be managed, even your long term investments. By using the VIX you can estimate the coming trends in the market. Using the VIX in combination with seasonal cyclical trends can give you advantages when purchasing or selling stocks.
(Note: The above information is not for investment purposes, but solely for entertainment purposes only.)
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