The markets have been volatile this month. Unfortunately experts say most investors will react badly.
Wall Street seems to have a measure for everything — and a way to bet on it too — so it’s no surprise that there’s a proxy for investor apprehension. The VIX (pronounced “vicks”), short for the Volatility IndeX, and nicknamed the “fear gauge,” tracks the price of an option on the Standard & Poors 500 stock index. When the VIX goes up, stocks are generally dropping, and investors are wary. There are plenty of reasons for anyone to feel antsy these days: The Greek economic crisis, the May 5 “flash crash”, regulatory debates in D.C., etc. On May 20, the VIX hit 46, its highest level in over a year.
Some think a high level of volatility may be here to stay. In testimony May 20 before a subcommittee of the Senate Committee on Banking, Housing and Urban Affairs about the rapid market drop of May 6, Larry Liebowitz, Chief Operating Officer of NYSE Euronext argued that with modern technology “fear gets transferred to the market faster than ever.”
Unfortunately, experts in market volatility argue that while fear can be smartly played by investors, mostly it isn’t. In a May 20 piece in Barron’s Bill Luby, an investor and newsletter author who’s penned a book on the VIX, explained that historically investors tend to underestimate the chance of a big spike in volatility, and then overestimate volatility as it receeds.
In some respects, predicting a volatility storm is like trying to predict a hurricane. Yes, some Category 5 hurricanes occasionally make landfall at full strength, but the large majority of these never become as strong as feared, veer off course or lose their potency. Investors have a tendency to underestimate a large volatility spike…On the other hand, once volatility has already spiked and appears to be on the decline, investors are most susceptible to overestimating volatility. I call this phenomenon “disaster imprinting” in order to pay homage to the scars that events like those of 2008 leave on an investor’s psyche.
Regularly investing in and rebalancing a portfolio of holdings seems to be one of the easiest ways to minimize the impact of an up and down stock market ride. Research by fund giant Vanguard Group found that portfolios that are never rebalanced have significantly higher volatility than those that are regularly re-aligned. Another expert on risk, Zvi Bodie, a professor at Boston University, argues that most investors have too much exposure to risk. His advice is that savings for basic needs — like the majority of your retirement savings, or a college fund — should be covered with ultra-secure investments such as the U.S. Treasury’s TIPS and I-Bonds. Beyond that, if you still have money to invest, he advocates putting it into a well-diversified portfolio of stocks or no-load mutual funds.