The Volatility of Volatility: What You Need to Know About the VIX

No matter the goal or time horizon, all investors are looking for a positive return on their investment, and in the stock market that usually means buying low and selling high. Accordingly, low prices are great for buyers and bad for sellers. As clear cut as this seems, the real story behind a sound investment strategy is much more complicated, because of volatility.
Volatility is often considered investors’ biggest enemy, but there are many reasons why you should consider volatility a welcome and necessary part of financial markets.
For one, the concept of volatility is often misunderstood, and characterized as fear in the market. The volatility index for the S&P 500, known as the “VIX,” is sometimes called the “fear” index, because it rises at times when investors are most fearful, and are looking to protect themselves from a market downturn.
While this is often true, the VIX is simply a measure of the market’s expectations for price changes in the S&P 500. If prices are expected to change radically, or if investors are growing fearful that a market is about to face uncertainty, the VIX will rise.
While it often causes panic, a rise in the VIX can be an opportunity as well. If your time horizon is long and you are well diversified, a spike in the VIX can be a good thing. Here’s why.
1. Avoiding Bubbles
A rise in the VIX often coincides with a downturn in stock prices, and this isn’t necessarily a bad thing. For instance, in early 2014 volatility spiked shortly after the S&P 500 brought a total return over 30% in just one year. Such growth, partly bolstered by the Federal Reserve’s quantitative easing, is unsustainable in the long term, and the market recognized this fact in early 2014 when a mix of a decline in prices and a spike in the VIX signaled a much-need change  in the pace of asset price growth. The market delivered this, and the S&P 500 saw a slower, but still robust, level of growth in 2014, ending the year 12% higher.
2. Volatility and Entry Points
 
Volatility and the price declines that come with it are by definition bad for sellers, but great for buyers. For anyone still accumulating stocks with a long-term time horizon, the short-term fall in prices is a very good thing. It means the market is on sale.
The fall in prices in early 2014 is a great example of this in action. An investor who made consistent, periodic purchases of an index fund tracking the S&P 500 ended up getting a higher than 12% return, annualized, thanks to lower prices as a result of volatility in February, April, August, October, and December.
 
This is a key reason why volatility is not bad for investors: when volatility is up, the market is on sale, and it’s a great time to buy and hold.
 
3. Dividends and Volatility
 
Another great reason to welcome volatility is the impact it has on a dividend-focused portfolio. When volatility and asset prices fall, the dividend yield on those stocks rise. For instance, if we take a look at AT&T over the past year, we see the stock went from 31.74 to 37.48. Those who bought in at the lower price point are getting a 5.92% dividend yield; those who bought on the higher end got it at a 5.02% dividend.
That’s a big difference, and the lower-cost income is simply thanks to fear and volatility in the market. This is one of the reasons why Warren Buffet urges investors to get greedy when others are fearful.
 
3. Volatility Has Dwindled
With this concept in mind, patient investors might be disappointed to learn that, since the global financial crisis, volatility has gone down considerably. While it seems to have recovered in recent months, it seems that the radical market corrections of the past have become less likely in today’s stock markets:
This chart shows the value of the VIX from 2007 to the present. Immediately, one trend is clear: the spikes are getting smaller and smaller, and the low troughs are lasting longer and longer. The latest volatility spikes of late 2014 and early 2015 are the highest rates since 2012, and far below the average rate since 2008.
This means that volatility has been going down, which suggests two things. First, it means less investors are expecting a major correction. Secondly, it means we are seeing less corrections. Neither is necessarily a good thing; a lack of corrections means higher prices, which means stock portfolios are getting more and more expensive for buyers.
 
How to Invest with Volatility in Mind
 
Many investors wonder how they should invest when volatility is rising. And the answer to that is simple: invest just like you would when volatility is falling.
The key to higher longer term returns is having a strategy that works for your unique situation, and sticking to it. As we see from above, a retirement portfolio that keeps to its investment plan in times of high volatility will actually outperform those who try to avoid the fearful market. With time, patience, and perserverance, investors who know their plan and stick to it will always have a much bigger nest egg waiting for them when they need it.
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