Don’t Fear the Fear Index

Don’t Fear the Fear Index

Have you ever watched a real-time feed of market indexes?

Chances are you’ve turned to a favorite app or news source when the stock market is rising or falling for a live look at how the markets are performing.

On a day when the markets are experiencing deep drops — often a bigger attention-grabber than upward climbs — the major market indexes will tick away in red numbers with glaring minus signs. Look down the list a bit further and you may be greeted by a lesser-known index, the VIX, as a green number ticking upward.

The VIX is the Volatility Index — a real-time index created by the Chicago Board Options Exchange in the 1990s to offer a feel for the 30-day forecast of market volatility. Not only does it attempt to gauge market risks, but it also encapsulates the moods and sentiments of investors.

The financial markets often are a reflection of the sentiments of investors, and we can expect to see rises and falls accompanying major news events. In today’s case, the coronavirus grips market sentiment.

Due to the emotional tie-in with these events, the VIX is sometimes referred to as the “fear gauge” or “fear index.” Although it should be noted that the VIX will react to market upswings as well, especially when they are considered as part of a rapidly fluctuating market scenario.

The term volatility is also applied to individual stocks and funds when they have wide swings between earnings and losses. A volatile stock or fund is considered to be a higher-risk investment but may also have a higher return, while lower-risk investments will perform in a more stable manner, with returns adding up more slowly over time.

Justin Kuepper of Investopedia explains that “Volatility often refers to the amount of uncertainty or risk related to the size of changes in a security’s value. A higher volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction.”1

There is more than one method of calculating volatility, and each has its advantages and disadvantages. None is perfect, and each hinges on underlying assumptions that may or may not bear out.

As a general rule, the VIX moves up when the major market indexes are falling and bumps downward when the markets are on the advance and fears and uncertainties decline.

“In absolute terms,” explains Kuepper, “VIX values greater than 30 are generally linked to a large volatility resulting from increased uncertainty, risk and investors’ fear. VIX values below 20 generally correspond to stable, stress-free periods in the markets.”2

To get a historical perspective, consider the strong, stable market of 2006–07 with the VIX averaging just below 13.5. But as market turmoil hit in the fall of 2008 amidst a global financial crisis, the index spiked to 80 points over the course of the fourth quarter.

Compare that with the levels of 85 hit last Wednesday and one might be concerned…

“Don’t let the VIX vex you,” advises Qtrade Investor. While it is a snapshot of how the market is feeling at a given time, it  doesn’t always show long-term risk. Instead, QTrade advises, consider it an indication of what could come in the markets, and as a possible indicator of “the quiet before another storm.”3

What should the average investor do when the market is volatile?

It’s important to step back from any emotion and fear surrounding the volatility and avoid making impulsive decisions. Generally, this is a time to sit tight and wait for the situation to resolve itself and market strength to return, as it invariably does.

For the investor willing to engage in more risk, a volatile market presents an opportunity for some bargain shopping on the stock market, as well as stepping out and taking the risks such as options trading, which attempts to profit from anticipated volatility. Such steps should be taken with the guidance of a trusted financial adviser.

Discover Bank advises that the best course for the average investor is to “Keep calm and carry on,” despite the roller coaster feelings one can get from a volatile market. They warn against reactive decisions based upon short-term fears and remind investors to keep the long game in mind.4

Risk can be managed with diversification and solid financial guidance, as this spreads out risk and gains in some areas will offset losses in others. Another tip — avoid obsessing over a given day’s numbers and take a break from market watching. Focusing on paper losses can just fuel decisions that may lead to regrets.

A volatile market should ultimately be seen as part of the natural course of events, a learning experience and an opportunity to broaden your investment perspectives.

With purpose,

Patrick Gentempo

Patrick Gentempo