"Be greedy when others are fearful, and fearful when others are greedy." This famous quote by Warren Buffett essentially means that markets tend to overreact in times of great uncertainty and also to become inflated during periods of irrationality.
Whether in times of fear or in times of complacency, investors should stick to their investment convictions, which may require that they go against the general market sentiment. This kind of investment discipline often pays off over time.
In a recent article by Bloomberg, Whitney Kisling and Nikolaj Gammeltoft report that investors who have bought the market in times of panic, as measured by the Chicago Board Options Exchange Market Volatility Index, have seen an average return of 3.2 percent in the next three months and 19 percent over the next year. The data goes back to 1986, when the VIX was created.
Often referred to as the fear index, the VIX is derived from a weighted blend on options on the S&P 500
Index. It represents a measure of the market's expectation for volatility over the next 30 days. While volatility can mean that the market can move up as well as down, an increase in the VIX doesn't likely portend an upward surge, but rather it indicates bearish sentiment.
The VIX broke 40 for only the sixth time in its 24-year history when the markets sold off this past August. The spike in the VIX coincided with a day's 6.7 percent decline in the S&P 500 after the market reacted to Standard & Poor's downgrade of U.S. debt.
Each time the threshold of 40 has been broken, it has been because of a reaction from a major event or crisis, including the Sept. 11, 2001, terrorist attacks, the dot-com implosion and the 2008 U.S. financial crisis.
The last time the VIX broke 40 was in May 2010, as concerns were heightened over the European Union's ability to contain a Greek default. The 12-month return of the S&P 500 since that day was 24.4 percent.
Many institutional investors believe that when the VIX spikes above 40 it indicates that the market is oversold and near a bottom, despite what's happening in the economy. However, caution should be taken if considering investing solely on the basis of a high VIX.
You can drown in a lake that is 6 inches deep.
While average returns have been positive using this investment method, using averages can be dangerous. Depending on the timing, investors can experience severe losses if jumping in when the VIX crosses 40.
For example, during the U.S. credit crisis, the VIX crossed 40 on Sept. 29, 2008. If you had invested in the S&P 500 that day, your investment would have been down approximately 28 percent six months later. One year later, that same investment would be down about 4.5 percent.
Extreme volatility can be a test of investment conviction. History has demonstrated that investors who have built a solid and diversified portfolio of investments in line with their goals and objectives should not dump their holdings when the market is in a panic.
Rather, they should use those opportunities to their advantage and make a decision based on objectivity rather than emotion.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken, CFA, is vice president of investments with DeMoss Capital at demosscapital.com. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at firstname.lastname@example.org.