The markets are said to be driven by fear and greed. In a 1986 Berkshire Hathaway shareholder letter, Warren Buffett described his investment philosophy as "attempt[ing] to be fearful when others are greedy and to be greedy only when they are fearful."
It wasn't until I started working as a financial advisor that I got to see firsthand how the fear and greed dynamics worked. Too much excitement or greed -- especially among my clients who were usually very apprehensive about stocks -- was not usually a good sign. When my most rational of clients started speaking as if the rug was about to be pulled out from under them, I knew that the level of fear investors were feeling was high.
These days, I'm no longer working as a financial advisor, but I still get significant benefit in my personal portfolio from tracking investor sentiments.
The Volatility Index, most commonly referred to as VIX, gauges the market's expectations for volatility over the next 30 days. This index is also known as the fear index, because its movements are supposed to mirror how fearful (or not) investors are about the markets. When the VIX is trading high, it is said to indicate higher levels of market fear. When the VIX is trading low, it is a sign of less fear.
Active traders use the VIX to help them make investment decisions on a daily basis. I'm not an active trader, but I still use this index to help me make investment choices.
When I want to decrease risk
Over the last 20 years, the VIX saw sharp spikes or highs in October 2008 and March 2020. These spikes coincide with the two most significant bear markets over that period of time. Just before then, the VIX was trading at low levels.
When the VIX is trading at low levels but increasing, this could be a sign of a possible pullback. Rather than jumping on the bandwagon, I use this information as a sign to consider decreasing my portfolio's overall risk.
Keep in mind, however, that timing the markets is very hard. Using the VIX to try to avoid a market bottom may bring some peace of mind -- as it does for me -- but it's very possible that the bottom may not happen or could be short-lived.
Here's an example: In December 2018, a low but spiking VIX combined with a long-sustained bull market and the government shutdown in the United States made me believe that it was time for a pullback. I decided it was time for me to reduce my stock exposure, so I transitioned the proceeds into more conservative or non-correlated assets. Yet within a month, markets had recovered and were back on their run upwards.
Selling stocks to buy more conservative investments could lead to missing out on some market upside. It's also possible that the VIX picks up the highest level of fear after losses have already happened and some losses are still experienced.
It is for this reason that I only use the VIX as a supporting tool in periods of time when I am already looking to decrease my stock holdings. If my stocks have performed particularly well for a long stretch, I find myself with more stock exposure than I feel comfortable with. I then refer to the VIX to help me find the right time to rebalance out of stocks. If I'm not perfect with the timing, I still feel comfortable because it was an action I'd decided to take anyway.
When I'm in search of investment opportunities
When the VIX measures high levels of fear, it trades high. Investors who are fearful and panicking may overreact, driving stock prices down -- and equities that were trading at expensive prices relative to their values become more affordable. I am very optimistic about the long-term prospects of the stock market, so this is the perfect time for me to swoop in and buy.
When the markets started to dive because of the COVID-19 pandemic in March, I believed that this was a perfect opportunity to buy stocks. For the most part, stocks had been upward bound since their recovery in 2009 and were trading at all-time highs. This pullback didn't last long, but it was significant enough to allow me to buy SPDR S&P 500 (NYSEMKT:SPY) at a lower price.
Because the VIX measures short-term volatility, it's essential to remember that it should not be used to time the markets. Rather, look out for market trends -- and do your research to find companies that have great management and a great line of profitable investments.
The VIX is not a perfect science. Investors looking to add stocks into their portfolios should look for companies that have strong financials, like consistent and growing dividends and a strong revenue stream. Rather than using the VIX as the sole determinant of what you should do with your portfolio, use the index as a guiding resource in your overall investing toolkit.