How Scared Are You?

Well thought out investment strategies are usually most effective over the medium to long term. This is particularly true of strategies that incorporate investments that are easily tradable. This is because the intermediate value of such investments is likely to be affected by general investment sentiment as much as by relevant financial fundamentals.

Whilst it is important not to be overly sensitive to short term value movements, it is nevertheless a good idea to stay abreast of short term developments. At the very least, it will help to stiffen your resolve to take a long term view and not be panicked into a change of strategy. However, it might also encourage you to re-evaluate your long term strategy because sometimes, extreme short term reactions can have a damaging impact on long term expectations.

VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Market Volatility Index. CBOE is the largest (and oldest) US options exchange and handles around a billion derivatives contracts each year.

The VIX Index tracks the implied volatility of options on the S&P 500 Index (the 500 largest quoted US companies) and represents the overall market expectation of stock market volatility over the following 30 days. It is often referred to in the media as the Fear Index. The VIX Index is quoted as a percentage and relates to the annualised expected movement in the S&P 500 over the next 30 days. In other words, if the VIX were 20, the market would be expecting the S&P 500 Index to move up or down by 5.78% over the next 30 days (20% divided by the square root of 12).

A view of the chart (courtesy of the CBOE’s charting tool) shows 3 distinct peaks in the VIX over the last 5 years. These peaks represent times of extreme market stress, when investor concerns were at a systemic level. For example, the first peak shows that in the aftermath of the failure of Lehman Brothers in September 2008, the VIX Index nearly reached 80; which meant that the S&P 500 Index was expected to rise or fall (at the time, most likely fall having already fallen) by 22% over the following 30 days.

The second and third peaks both relate to problems in Greece at the time (strikes/social unrest followed by elections) which were seen as a possible catalyst for the disorderly break up of the Eurozone. Both peaks implied an expectation that the S&P 500 Index would, most likely fall, by around 12% over the following 30 days. However, it is to some extent reassuring that the expectation of financial volatility has been on a downward trend over recent years. Financial markets are no longer discounting widespread default although risk has certainly not gone away; it is simply that now the perceived risk is scope for variation in returns rather than scope for permanent financial loss.

As I alluded to in my previous article (Cold Turkey – Essence July/Aug 2013), financial markets are currently getting used to the idea of life without quantitative easing. Some tremors are likely as the dependency that currently exists dissipates. The possible economic consequences of increased instability in the Middle East also weigh heavy on investor sentiment.

The extent of market angst is reflected by the more recent (since May 2013) peaks on the VIX chart and compared to where we have been it looks somewhat less intimidating. Nevertheless, markets currently expect volatility in the range of plus or minus 5% over the next 30 days. Good enough reason to ensure that your own financial strategy still makes sense.