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Insights from The Mind Money Spectrum Podcast Episode #21
As a fee-only fiduciary financial advisor, my goal is to provide you with clear, actionable advice to help you achieve financial security and freedom. Understanding the complexities of the markets can empower your decision-making, but sometimes the so-called “market indicators” can do more harm than good when misused. One such indicator, widely cited but often misunderstood, is the VIX, commonly known as the “fear gauge.”
In this article, I will explain what the VIX actually measures, why it often fails as a reliable forecasting tool, and what you should focus on instead to build a resilient investment strategy. This information is especially relevant for high-performance professionals who want to avoid knee-jerk reactions and trade speculation for thoughtful, long-term planning.
What Is the VIX?
The VIX, or the CBOE Volatility Index, is a measure of expected stock market volatility derived primarily from the prices of S&P 500 index options. Put simply, it aims to capture the market’s collective consensus about how wild price swings might be over the next 30 days.
An average VIX value typically hovers between 15 and 20. A low VIX suggests a calm market environment where prices are expected to move within a relatively narrow band. Conversely, a VIX over 30 signals elevated uncertainty and potentially large moves—either up or down.
How Does the VIX Work?
To understand the VIX, imagine that options are like insurance policies on the stock market. Just as you pay a premium to insure your house against fire, investors pay premiums to purchase options that protect their portfolios from sharp declines (puts) or speculate on gains (calls).
The Black-Scholes model, a foundational equation in options pricing, uses several inputs—current stock price, strike price, time to expiration, risk-free interest rates, and expected volatility—to determine the fair price of an option. While most inputs are straightforward, volatility, especially implied volatility, is trickier. The VIX represents this implied volatility—market expectations for price swings—derived from those option prices.
Keep in mind that the VIX is annualized and based on the next 30 days, meaning the values reflect the standard deviation of the market’s return expectation over the upcoming month scaled to a year.
Why the VIX Often Misleads Investors
Despite its spotlight in financial headlines, I’m convinced the VIX is, for most investors, a largely useless tool when it comes to timing the market. Here’s why:
- It Does Not Predict Direction: The VIX measures expected volatility but is indifferent to whether prices will go up or down. High volatility means prices could swing widely in either direction—investors usually fear downside, but the actual outcome isn’t baked in.
- Mean Reversion Behavior: The VIX tends to spike in periods of fear, but those high readings are often followed by decreases. This cyclical nature means a high VIX doesn’t necessarily mean poor market returns in the near term, just increased uncertainty.
- Noise and External Events: Sudden geopolitical events, pandemics, or unexpected economic reports can cause jumps or drops no indicator can foresee. The VIX might spike after the fact but rarely provides early warning.
- Short-Term Focused: Since it’s a 30-day expectation of volatility, the VIX’s utility beyond the very short term is limited. For long-term investors, these short-term ripples seldom matter.
- Complex Options Market Influence: The price of options—and thus the VIX—can be affected by market mechanics such as liquidity, supply and demand, or speculative activity unrelated to actual underlying risk.
Common Pitfalls With VIX-Based Trading Strategies
After the VIX gained mainstream attention as a “fear gauge,” various investment products based on it emerged—ETFs like VXX, inverse volatility ETFs, and so forth. These products are often pitched as short-term hedges or trading vehicles, but they have significant drawbacks:
- Decay and Theta Drag: Instruments tracking volatility tend to erode in value over time because of the way volatility futures are structured.
- Not Suitable for Buy-and-Hold: Unlike stocks or bonds, these ETFs are insurance products that lose money if held long term.
- Sudden Spikes Can Cause Catastrophic Losses: The inverse volatility products suffered enormous losses during sudden market shocks, wiping out investors who held them too long.
- They Are Costly Insurance: Continuously buying protection via volatility products or options premiums can slowly erode your returns, often without realizing a payoff.
What Should High-Performance Professionals Do Instead?
For those of us focused on long-term financial security and freedom, here is my practical advice regarding market volatility and the VIX:
1. Embrace Volatility as Part of the Investment Journey
Volatility is inevitable and, in fact, a natural component of investing in stocks and bonds. Instead of fearing it or trying to time it, recognize it as the price of participating in growth. Over long horizons, volatility smooths out.
2. Maintain a Well-Diversified Portfolio
Diversification across asset classes, sectors, and geographies is one of the best ways to reduce unexpected swings. Bonds generally provide ballast during volatile periods, so don’t neglect them.
3. Align Your Asset Allocation with Your Risk Tolerance and Time Horizon
Instead of reacting to market fears or chasing volatility signals, set a strategic allocation based on your goals, income, liquidity needs, and psychological ability to withstand downturns.
4. Avoid Market Timing Based on Volatility Measures
Trying to “get out” when the VIX is high or “get in” when it is low is a losing game. The market often moves irrationally in the short term, and the VIX itself is a lagging or coincident indicator rather than a leading one.
5. Use Dollar-Cost Averaging When Increasing Exposure
If you want to reduce risk of buying at a high point, a consistent, systematic investment plan will take advantage of market fluctuations without guessing the timing.
6. Consider Insurance As Needed, But Be Wary of Over-Purchasing Options
Options can serve as insurance tools against downside risk, but remember that constantly buying puts or volatility products will weigh on your returns due to premiums. For most investors, self-insurance—through a long time horizon and adequate emergency funds—is usually more cost-effective.
7. Consult with a Fiduciary Financial Advisor for Customized Guidance
Every investor’s situation is unique. Your risk tolerance, goals, tax situation, and income streams should dictate your financial plan—not impulsive reactions to volatility readings.
Final Thoughts
The VIX can be a fascinating data point to monitor from an educational standpoint—it reveals how option markets price uncertainty and fear. But for the vast majority of investors seeking financial freedom, it is a distracting and potentially harmful focus.
Markets are complex systems influenced by countless factors beyond what a single metric can reveal. Rather than trying to outsmart the market by chasing or escaping volatility signals, employ foundational principles that build durable wealth over time.
Sticking to a thoughtful, diversified portfolio aligned with your personal goals is the best defense and offense against market turbulence. If you find hearing about the VIX over 30 makes you anxious, remind yourself that it is just one of many signals—and mostly a noisy one at that.
Remember: Investing is not about predicting every movement but managing your money wisely for the life you want to live.
If you want personalized help to structure your investment portfolio, manage risk, or plan your financial future with discipline and clarity, feel free to reach out. My fee-only, fiduciary approach ensures that my advice aligns strictly with your best interests.
For more insights and financial planning guidance, visit InvestingForever.com.
Originally published: Tue, 05 May 2020 06:00:00 -0400
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