Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.
The S&P 500 (DJINDICES:^DJI) fell 2.6%, with a 38-point plunge in the index on Friday marking its worst drop since last June. But what many investors took even greater notice of was the fact that the so-called Fear Index, also known as the S&P Volatility Index (VOLATILITYINDICES:^VIX), soared more than 30% on Friday. Will the uptick in volatility turn out to be a short-lived phenomenon, or should investors start to prepare for more normal levels of choppiness in the stock market for 2014?
Will this strategy stop working?
In 2013, the right way to play volatility was to count on the stability of the stock markets. Along those lines, volatility-linked investments that were geared toward a lack of abrupt movements in the market performed best, with VelocityShares Daily Inverse VIX ETN (NASDAQ:XIV) more than doubling in 2013. By contrast, those investments that took the other side of the volatility bet, including iPath S&P 500 VIX ST ETN (NYSEMKT:VXX) and VelocityShares Daily 2x VIX ETN (NASDAQ:TVIX), suffered massive losses last year, with the iPath ETN losing about two-thirds of its value and the leveraged VelocityShares ETN plunging about 85%.
So far in 2014, those investments have reversed direction. The pickup in volatility has sent last year's losers higher, albeit not by anything close to the amounts they lost last year. Similarly, last year's winners have lost a modest amount of ground in 2014.
But it's important to remember that even in the relatively calm 2013, stock market volatility occasionally rose to extremely high levels. During the initial fears surrounding the Federal Reserve's deliberations to end its quantitative easing program in May and June, interest rates on bonds soared, and that led to a big rise in volatility levels. Similarly, uncertainty about the government shutdown led to a short-term spike in stock market fear, and other unexpected incidents like the plunge in gold prices in April 2013 also led to temporary rises in volatility levels.
Overall, volatility in the stock market tends to be a fleeting phenomenon, with long periods of relatively quiet conditions punctuated by occasional dramatic rises to extremely high levels during difficult times for the financial markets or the broader economy. But the question is whether the low baseline levels of 2013 will persist in 2014, or whether we'll see a return to a higher base level. Although 2013's low volatility was commonplace during some past periods, including the mid-1990s and mid-2000s, we've also seen extended periods in the late 1990s and early 2000s when volatility consistently remained at higher levels.
Make volatility your friend
For long-term investors, the nice thing about volatility is that it can give you great entry points to buy stocks at desirably low prices. That's something that's been in short supply in recent years during the bull market, and those investors who can avoid falling prey to fear will be salivating at the chance to pick up stocks at bargain levels if the recent declines in the market turn into a full-blown correction.
Don't let volatility stop you from investing, though. Those who've stayed out of the market during higher-volatility periods after the stock market plunge in 2008 and early 2009 missed out on huge gains and put their financial futures in jeopardy. In our brand-new special report, "Your Essential Guide to Start Investing Today," The Motley Fool's personal-finance experts show you why investing is so important and what you need to do to get started. Click here to get your copy today -- it's absolutely free.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter: @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.