What is the VIX and why do investors care about it?

As we move through the news cycle it can appear as though the same playbook is being rolled out. The last couple weeks have been a classic example. A short and sharp fall in global markets was covered as the second coming of the great depression. The subsequent recovery in markets was ignored as the media abruptly moved on to more pressing matters like the Australian Olympic break-dancing uproar.

One part of the coverage of every market swoon is the breathless reporting on the VIX. The implication is that we are supposed to care about the VIX. What is left unsaid is why. I will attempt to explain the “why” in this article. But to be clear, I don’t care about the VIX. I don’t think you should either.

What is the VIX?

We can start with what the VIX is. The VIX represents expectations for volatility in S&P 500 share prices for the next 30 days. There are iterations of VIX for different indexes. The level of the VIX is based on the price of a basket of options that expire in the next month. It can be thought of as a crowd sourced view of how volatile traders believe the S&P 500 will be in the near term.

The wisdom of crowds is supposed to provide better insights into what will happen than relying on a few experts. The problem with relying on crowds is that the crowd can become collectively overly optimistic or pessimistic when it comes to investing or any emotionally driven pursuit.

This is the madness of crowds. We can be whipped into a frenzy by headlines like the ones we’ve experienced in the past few weeks. The VIX reading is both a manifestation of this frenzy and a driver as the VIX is often used as proof that markets are unstable.

There are countless studies of the predictive power of the VIX. The consensus is that it is a reasonable but imperfect marker of future volatility. With that context the question is if following the VIX should inform investing decisions.

Should investors embark on a pilgrimage to the VIX oracle?

I won’t bury the lead. It would be foolish for an investor to adjust their portfolio based on the VIX.

If the VIX is a reasonable predictor of volatility over the next month than a high VIX reading may mean the market has more of a chance in falling during that period. The only thing an investor could possibly do with this information is rotate into defensive assets. In theory the same investor that was relying on VIX as a trigger for adjusting a portfolio would rotate into growth assets if the VIX reading was low.

This is market timing. And market timing doesn’t work. It is also a one-sided reading of volatility. Volatility is often used as a proxy for shares falling. But volatility works in both ways. A volatile market means shares are bouncing around significantly.

The market may be unstable but investors should be wary of missing out on these periods. Over the last 30 years if you miss the S&P 500's 10 best days your return would be cut in half. If you miss the best 30 days – just an average of 1 day per year - your return would be 83% lower. And 78% of the best days occurred in bear markets when VIX reading are higher.

Are there other uses of the VIX?

The only possible use of the VIX is as a short-term market timing measure. Due to transaction costs, taxes and the fact that even informed guesses on short-term market movements are mostly wrong makes this a fool’s errand.

There is potentially one use of the VIX. Smart investors use volatility to their advantage. As Buffett says be “fearful when others are greedy, and greedy when others are fearful.” In other words - smart investors buy low. At first glance it may seem like VIX would be helpful for these smart investors.

The problem with using VIX in this manner is that it is designed to be a predictive measure. And an investor looking to buy low needs prices to actually fall before making a move. Buying before a fall is the opposite of a successful investment strategy.

Ignore the VIX and watch the market. Have a list of great companies that you want to buy if they get cheaper. Then pounce.

Final thoughts

If you care what happens with markets over the next 30 days you are taking the wrong approach to investing. If you have an investing time horizon in the decades you shouldn’t care about volatility. Markets will go up and markets will go down. But historically they’ve gone up.

We are inundated with data as investors. Successful investing is less a function of using data appropriately to make decisions than ignoring data that doesn’t help you achieve your goals. VIX is certainly an example of data that should be ignored. It makes for a nice talking point to paint a picture of turmoil and fear. And that sells papers. Successful investors know that these types of headlines have predicted 95 of the last 3 recessions.

Are there more pieces of data that you ignore or want to hear more about? Email me at mark.lamonica1@morningstar.com