Despite all the anxiety it can provoke, volatility can be just what the doctor ordered.
There’s nothing like good market volatility. It makes me sleep well at night. Plunging prices, several days of bad news, it makes me all smiles. No, I’m not a masochist. I just know that weak-minded investors become nervous and sell in a roller-coaster market, and that gives me more opportunities to buy at cheap prices.
It wasn’t always the case that I loved volatility. In my younger years, frightening drops led to restless nights and emotional selling. That didn’t do me any good because the market recovered every time! Today, I can look beyond short-term volatility and control my emotions. This puts me at an advantage over people who blow out of the markets when bears come hunting, and gives me a proven way for future gains.
Figure 1 illustrates the change in the Chicago Board Options Exchange’s CBOE Volatility Index (VIX) compared to the change in the S&P 500 price. The VIX is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, the VIX has been considered by many to be a key barometer of investor sentiment and market volatility. In general, higher volatility corresponds with falling stock prices and lower market expectations.
We haven’t had a good dose of volatility in quite some time. In fact, this summer, the VIX has been the lowest in five years.
Figure 1: CBOE S&P 500 price volatility and S&P 500 price return since 2010
Source: CBOE data through Aug. 5, 2014
Very low volatility always makes me nervous. It’s not that I fear higher volatility and a drop in prices; rather, some investors become complacent and begin buying stocks because they underestimate the risk. When “normal” volatility comes back, complacency can turn to apprehension, and this can cause ill-timed investment decisions.