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Many investors panic when market volatility increases, while other investors rejoice, as volatility often offers attractive buying opportunities. With this in mind, wouldn't it be nice to have some idea of the kind of volatility we can expect in the market's near term? Well, we can. There's a volatility index that you can check out any time you'd like.
Meet the VIX
The index I'm referring to is the Chicago Board Options Exchange (CBOE) Volatility Index, often called the "VIX." It reflects investor sentiment about the market's near-term direction by looking at options based on the S&P 500. (The S&P 500 is an index made up of 500 of America's biggest companies that often serves as a market benchmark.)
The higher the VIX volatility index is, the more expected volatility it reflects, while low readings suggest little volatility ahead. A VIX reading of 20 or lower is generally considered to reflect low expected market volatility, while readings of 30 and above are considered rather volatile.
While the index is based on investor opinions, and even their emotions such as fear, it has nevertheless tracked the overall market's movements closely -- but far from perfectly. The CBOE notes that between 2000 and 2012 the VIX was bullish about 82% of the time when the S&P 500 rose, and bearish about 78% of the time when it dropped.
That's pretty good, but it's also a reminder that the VIX always has a decent chance of being wrong. It reflects expectations of the future; but those expectations can change quickly if a major event transpires, such as a natural disaster, political or economic upheaval, or an industry in crisis, as happened to the financial sector seven years ago.
Don't let a little volatility scare you. The market doesn't rise in a straight line.
Should you care about this volatility index?
If you're a good long-term investor, as most would-be wealth builders should be, then you really have little need for any kind of volatility indicator. You can plow your excess money into your best investment ideas over time, and wait for them to perform over many years. When the market drops, as you should expect it inevitably to do now and then, you can seek out bargains. The VIX volatility index is focused on the short term, not the long, so it's not very relevant for long-term investors.
Long-term investors would be better served by focusing on finding great companies in which to invest. When doing so, don't be put off by companies that are particularly volatile -- or the fact that the entire stock market can be volatile. Indeed, stocks are generally more volatile than bonds, and at the same time, they tend to outperform bonds over most long periods.
Plenty of very volatile stocks have been great performers. You can get a sense of a stock's volatility by its "beta." A beta of 1.0 reflects a stock that generally moves in line with the market, while a beta of 1.2 reflects one that's about 20% more volatile. Priceline, for example, sports a recent beta of 1.4, and has averaged annual gains of 30% during the past five years. With a beta of 1.3, Amazon.com has averaged gains of 29% annually during the past decade.
That said, overall, low-volatility stocks have tended to outperform high-volatility ones in most markets. So you can do well with high-volatility stocks and low-volatility stocks, though the odds are in favor of the latter.
In short, the VIX volatility index can be interesting, but most of us have little use for it.
