Vexed by the VIX
This past week a number of articles spilled forth regarding the VIX index being at record lows. If you aren’t familiar with the VIX, that’s quite okay; the VIX is an index that tracks the nervousness of investors. The lower the VIX is the more confident investors are. The higher the VIX, the greater the concern.
At first glance the VIX seems to clearly tell us…something. At least it seems like it should. The index is really a measure of volatility using an aggregate of prices of options traded on the S&P 500, estimating how volatile those options will be between the current date and when they mature. The mechanics aren’t so important for our purposes, just that this index has become the benchmark for the assumed fear or comfort investors have with the market.
So what does it mean when the VIX is supposedly at its lowest point in nearly a quarter of a century?
Because we live in the 21st century, and not some other more primitive time, we have the best technology and research to look to when it comes to discerning the meaning of such emotionally driven statistics. Its here that the the area of study of behavioural economics and investing supposedly cross paths and that we might be able to yield some useful insight from the VIX.
The holy grail of investing would presumably be something that allowed you to accurately predict changes in the market based on investor sentiment. Though over time stock markets are meant to be an accurate reflection of the health and wealth of an economy, in the short term the market more closely tracks a series of more micro events. Investor sentiment, political news, potential scandals as well as outside influences like high frequency trading and professional traders pushing stocks up and down all make up daily activity.
The VIX seems like an ideally suited index to then tell us something about the market, and yet it probably isn’t. The problem with research into behavioural economics (and its other partner, big data) is that it is great at telling us about things that have already happened. The goal, that we could use this information to change or alter human behaviour, is still a long way off (if it exists at all). Similarly the VIX is basically great at telling us stuff that we already know. When markets are bad the VIX is high. When markets are good its generally low.
Thus, the VIX represents a terrible forecasting device but an excellent reminder about investor complacency. When markets are “good” (read: going up) there is a tendency for investors to ask for more exposure to those markets to maximize returns. If you feel uncertain about the future, investors and financial advisors are less likely to “drift” in terms of their investing style, but if people feel very good about the future their far more likely to take their foot off the breaks.
Real market panics and crashes tend to be triggered by actual structural problems. 2008 wasn’t the result of too much confidence about the future from investors, but because the market itself was sitting on a bubble. That the VIX was low only tells us what we already knew, that we weren’t expecting a financial crisis.
With markets down sharply yesterday its tempting to see that this level of investor complacency/confidence harbingered the most recent sell off. But that’s not the case. Trump is, and remains, a kind of nuclear bomb of unpredictability that must be factored into anyone’s expectations about the markets. But what we should do is consider the VIX a mirror to judge our willingness and preparedness to deal with unexpected events and market downturns. If you’ve started to assume that you can afford growing concentration in your portfolio of high performing equity or that you don’t need as many conservative positions, you should take a long hard look at why you feel that way. Maybe its just because you feel a little too confident.
Like everyone else.