World markets have seen a spike in volatility over the past few weeks as stock prices have gyrated wildly. Sparked by uncertainty over the Chinese economy, European monetary policy, and the possibility of a U.S. interest rate hike, investors have begun to show signs of panic. General stock market volatility in the United States is measured by the CBOE Volatility Index, or VIX. The VIX uses implied options prices on the S&P 500 index to gauge expectations for 30-day future volatility.The level of the VIX index is used by investors to measure investor confidence, and is sometimes referred to as the “fear index”, with higher values indicating greater uncertainty.For the years following the Great Recession, stock markets rose slowly and steadily as economic fundamentals began to recover. In fact, the past six years have been largely characterized by historically low price volatility and a persistent bull market.
In August, the VIX reached levels in excess of 40, the highest readings in years. To put things in to perspective, the VIX rose to nearly 80 during the Lehman Brothers collapse. Generally speaking, VIX levels above 20 or 30 indicate that investors are worried, and levels below 20 indicate that investors have confidence in stable, rising markets.
Volatility measures both how much and how quickly asset prices move, regardless of direction. In other words, it is a measure of the degree of variation of prices measured over some period of time. If asset prices are distributed in a known fashion, such as over a normal distribution, the volatility is measured by determining how many times the price moved a given number of standard deviations from the mean.
Stock market volatility relies on a log-normal distribution, which acknowledges that stock prices are bounded by zero to the downside, but have unlimited upside potential.
People generally fear a downward move in prices, and are much more concerned with a 10% drop than a 10% increase over a similar period of time. This is why measures of volatility levels, such as the VIX, are positively correlated with down moves in the market.
Increased volatility predicts near-term economic downturns, bear markets, or a crisis. Volatile markets can cause investors to behave irrationally and can lead to a decrease in liquidity.
For those reasons, short-term financial decisions should take increased volatility under consideration. But over the mid- to long-term however, it may be wise for most investors to ignore sudden swings in market volatility. Here is why:
1. Volatility Tends to Revert to the Mean
The level of volatility for markets, as well as for individual assets, tends to exhibit the property of mean reversion. Put plainly, there will be an average (or mean) level of historic volatility established over time that future levels will return to. If volatility spikes to levels well above the mean, then over time it should decline back to that average level. If observed volatility levels are quite a bit lower than the average, over time the volatility should be expected to increase.
Over the long run, volatility levels should smooth out and return to the average. Of course, over long time periods, the average level itself may fluctuate. That’s why a moving average level is often used as the benchmark.
One can see this phenomenon by comparing short-term volatility levels, such as 30- or 60-day volatility, to longer term volatility levels, such as 180- 250-day or longer. For example, current 30-day historical price volatility for the S&P 500 ETF, SPY, is a around 27 right now, while 180-day volatility is closer to 23.
For investors with long-term horizons, spikes in volatility shouldn’t be cause for panic trades.
2. Volatility Can Induce Human Irrationality
Following a herd mentality and falling victim to fear can cause investors to behave irrationally and increase volatility levels as they sell on lows and take losses. Behavioral finance explains how emotional and cognitive biases can cause poor outcomes for investors, who may be better off simply waiting things out.
People tend to be loss averse, rather than risk averse. Individuals respond with greater emotion to a loss than by a gain of equal size. Worse still, many people will become risk-seeking when facing a loss, like a gambler will double down his bets at the casino just with hopes of breaking even. The result of this irrational behavior often deepens actual losses.
Respected professional investors from Warren Buffet to Vanguard’s John Bogle have vocally warned the public to sit back and ignore market volatility, lest they fall victim to their own fallibility. A well-diversified portfolio based on sound fundamentals should be able to weather short-term bouts of volatility. In fact, stock markets across the globe are now trading at higher levels than before the crash of 2008. Markets will naturally fluctuate and may post negative returns from time to time. As another example, the S&P 500 has had a compound average growth rate (CAGR) in excess of 10% total return over the past one hundred years.
3. Bear Markets Allow Investors to Buy the Dips
For an investor with a well-defined investment strategy, who invests and re-balances regularly and systematically, volatile markets can actually provide a benefit by allowing them to buy shares at lower prices than they would be able to otherwise. For example, retirement savers who save a portion of their income each month to contribute to a 401(k) or IRA account and do not deviate in volatile markets will benefit from dollar cost averaging, creating a lower overall average purchase price for the shares that they end up owning.
Investors who were able to keep a cool head, and recognize that stock prices were “on sale” during recent bear markets or even intraday during flash crashes, bought shares to improve their average purchase price.
The Bottom Line
Volatility measures how much, and how fast price swings occur, and is often accompanied by investor fear and uncertainty about the near-term. The VIX index, sometimes called the “fear index” is a widely used to measure broad market volatility in the United States, and VIX levels have spiked in the last few weeks as a result of market gyrations caused by uncertainty in China, Europe and at home.
While volatility can be a predictor of short-term bear markets or economic downturns, long-term investors are wise to ignore increased volatility and maintain their strategic investment goals. Volatility levels tend to revert to the mean, so even high levels are expected to return to normal over time. Investors who fall victim to fear may act irrationally and lock in losses, or even make their losses worse. A cool-headed investor who understands this can benefit from volatile markets by following a systematic dollar-cost-averaging approach and pick up stocks at bargain prices to hold for the long-term.