All Articles/Financial Planning/Why Long-Term Investors Should Ignore the VIX

Why Long-Term Investors Should Ignore the VIX

Volatility can be upsetting but remaining in the market brings rebound benefits.

Chicago Flag

NOBODY LIKES THE roller-coaster ride of a volatile market. For many of today’s investors, volatility stirs up anxiety that’s reminiscent of the sharp decline that began in November 2007 and finally reversed higher in March 2009.

Of course, some investors don’t follow every up- and downtick of the equity markets, and that’s a healthy approach for those with a focus on the long term. At any given time, the current politically charged environment also makes investors believe markets are flashing sharp downside action, when in fact, indices may be flat or trading higher.

It’s easy to see the actual levels of volatility by looking at a chart for any given index, such as the S&P 500 or the Nasdaq Composite.

What is The VIX?

Another widely used method of gauging volatility is the Chicago Board Options Exchange Volatility Index, generally dubbed “the VIX.” This index, constructed from prices of S&P 500 options, offers a glimpse into market-wide investor sentiment.

In theory, because it’s built upon actual data, the VIX is a better indicator than the opinion of a television personality or any other pundit. If investors are growing nervous and their options trades are reflecting this, the VIX will spike higher.

The past couple of months, the VIX has been on the decline, signaling that investors may be feeling more optimistic and less frightened. The most recent index spike was in early May, just before the S&P 500 began a downturn that resulted in a monthly decline of 6.58%.

The VIX began trending lower, indicating better market sentiment, in early June, as the S&P 500 turned higher. The S&P 500 finished the month with a gain of 6.44%, erasing May’s decline.

Does this mean the VIX should be your indicator for trading? If you are a long-term investor, the answer is an unequivocal no.

During bouts of heightened volatility, it’s a good exercise to remind yourself of your investing goals. In most cases, it’s retirement. More specifically, investing in a way that combines growth with income generation, while also preserving capital so you don’t outlive your money.

It’s not easy to sit through short-term volatility. In the grand scheme of things, a month is a short period of time, although it doesn’t usually seem that way when we are experiencing a series of nervous moments. It’s tempting to sell out and wait on the sidelines with a pile of cash, but you risk missing the next market rebound, which usually arrives just as the pundits are predicting further doom and gloom.

When To Invest

It’s a cliche, and one that’s not easy to act upon, but the idea of buying low is a benefit. If you have cash that’s not invested, it may be terrifying to contemplate making stock purchases. But haven’t you heard stories of people who invested in the market during a correction, or started a business during a recession? In hindsight, those decisions appear brilliant and even self-evident.

Recent data published by mutual fund management firm Franklin Templeton showed that those who stuck with markets throughout downturns were rewarded over the long haul. Even with intra-year volatility, the S&P 500 had positive total returns in 25 out of the past 31 years.

In the heat of the moment, few investors have the intestinal fortitude to hit the “buy” button. Markets may decline further after such a decision, giving investors buyers’ remorse. Even if there were any such thing as a perfect time to buy, it would require the stars to align in a once-in-a-lifetime miracle for you to nail that exact moment. In other words, there’s always something to kick yourself about when it comes to market timing, which is why it’s best avoided, no matter what volatility indexes tell you.

A 2016 study by Dimensional Fund Advisors showed that recent spats of volatility do not indicate whether future market returns will reward or disappoint investors. As a long-term predictive mechanism, market volatility has no practical application.

History has shown that markets do indeed rise, over time. In the short term, volatility has been no stranger to equity indices. There’s no reason to believe that will stop any time soon. Investors would be well served to expect volatility, rather than fear it, but that’s easier said than done.

Index Guidelines

It’s not as exciting as trading based on a volatility index, but a broad-market allocation of stocks and bonds, fine-tuned for your unique situation, will help you weather downturns more easily than a practice of shuffling in and out of the market as volatility spikes.

About the Author

Better Money Decisions