When planning your investment strategy in a high volatility market, it’s always important to understand what characteristics pose the greatest threat to your portfolio. While one can never perfectly predict what the markets will do next, there are some tools that are helpful as indicators.
The Fear Index
By constantly tracking the swing of price movements, the VIX or "fear index" measures the amount of volatility facing the market and acts as an indicator as to what may happen next. What causes movement in this fear index? Typically, the movement is caused by a number of variables. Factors such as energy supply and prices, geopolitical risks, economic performance and emerging market environments all play a role in the daily fluctuation of market volatility. (For more, see: The Volatility Index: Reading Market Sentiment.)
Investors may look at this measure of risk in the market and try to use it as a tool to anticipate what their next move should be. During times of higher volatility, short-term predictions often lead to mistakes that result in losses, making it nearly impossible to guess which way the market will trade. It’s important to keep in mind that while market volatility increases portfolio risk, it is often investor reaction to this index that is the prime source of risk to one’s portfolio.
To help protect investors from market risk (and themselves), implementing a lower volatile portfolio strategy - incorporating long-term, lower-risk holdings - can yield success. This type of approach may help preserve portfolios, minimize price swings and cultivate more consistent returns. So, how may this be done?
Low Volatility Investment Strategy
Because the market is constantly changing and no two periods are identical - each varies in time span, volatility and returns - it is imperative to adopt a strategy that is designed to perform well in various conditions. Finance 101 familiarizes students with the theory that higher risk leads to higher returns. However, research has shown that this concept is not entirely true. Dating all the way back to 1972, the relationship between risk and return has been proven to be either disproportionate, flat or negative.
An S&P Dow Jones Indices study (2012) stated that, “Empirical evidence of numerous academic studies has illustrated that low-volatility or low-risk investing outperforms the broad market as well as high-risk strategies over a long-term investment horizon with much less realized volatility.” Because of this, the possibility of owning a portfolio with lower risk and higher returns provides cause for serious due diligence and consideration. Not only have investors seen better returns, these portfolios have historically offered greater downside protection, diversification and transparency throughout a complete market cycle. The best example of this would be low volatility investment performance in times of recent crises. (For more, see: Tips for Investors in Volatile Markets.)
As established throughout history, the unpredictability of the market can leave investors vulnerable to downturns, bubble bursts and bearishness. Since 1990, the United States has experienced two major crashes that resulted in major economic repercussions. In 2000, following the tech sector boom, the dotcom crash saw trillions of dollars worth of stock value lost and the NASDAQ suffer a 78% decline from peak to bottom.
Later in the decade, over the span of 2007-2008, the combination of the housing market bust and credit crisis led to another major crash - this one resulting in both a 57% decline of the S&P 500 and a record breaking 777.68 point drop in the Dow Jones Industrial Average in a single day. Both crashes were followed by recessions and greater stock market volatility, hurting investors and their portfolios.
However, in those turbulent times, portfolios that were composed of lower risk holdings were able to escape most of the heavy hits on returns. The S&P 500 Low Volatility Index shows that, in back-tested results, low-risk portfolios outperformed the S&P 500 throughout crashes and market uncertainty on top of providing more capital protection and the ability to produce returns in negative markets.
While it may seem appealing to chase the latest, hottest stocks, in reality, a portfolio that’s built with higher quality, lower risk assets are what helps investors participate in and benefit from bull markets without sacrificing safety during draw downs. (For more, see: Volatility's Impact on Market Returns.)