Volatility is an indication of risk. The more volatile the price (or return), the greater the perceived risk. This simple relationship is largely behind the fact that bonds are less risky than shares. Volatility in returns is one of the key differences between the two asset classes and (spoiler alert) therein lies the answer to protecting your portfolio again excessive volatility
What is the VIX or so-called “fear index”
There is a strong connection between fear and volatility. It is often said that greed builds slowly whereas fear acts fast and with large, violent moves. Volatility is greatest in uncertain times.
So the question for investors is how do we objectively measure volatility and how can we protect investment portfolios against it?
The most widely used and quoted measure of volatility is the VIX index. Given the relationship between volatility and fear it is also commonly referred to as the “fear index”.
VIX is the ticker symbol for the Chicago Board Options Exchange Market Volatility Index. It measures the level of implied equity volatility with reference to options on the US S&P 500 Stock Index. It is a real-time measure which provides crucial data to investors on the psyche of the market.
While the technical calculation methodology is a little complicated, the important point is that volatility is correlated to equity market moves. Behaviour is very different when equity markets are improving compared to when equity markets are declining. In general, most rises are slow and small, while most falls are quick and large (i.e. volatile).
In simple terms, we look to the VIX to tell us when uncertainty, risk, and even fear is increasing.
When the market expects declines in equities, the VIX rises, and rises dramatically. As the chart below demonstrates, increases in the VIX (dark blue line) are generally associated with declines in equities (as represented by the US S&P 500 index in grey). This was most stark in the GFC.
However, there is also a relationship between bonds, equities and the VIX. Typically periods of uncertainty see a flight to quality from equities to bonds. Notice in the chart below how the price of the bonds (as represented by US Treasury 2037s in light blue) increases when the VIX increases and equities decline.
How to protect your portfolio against volatility (and falling equities)
It is the countercyclical mechanism of fixed rate bonds that provides the answer to protecting against volatility and in particular declining values from the equity portion of your portfolio.
Depending on your risk appetite and ability to withstand volatility, an allocation to bonds (particularly fixed rate bonds) will greatly reduce the overall volatility of your investment portfolio.
While we have used US data in the above, the exact same relationship occurs in Australia.
The following checklist is a useful tool for all investors. Typically speaking, a spike in the VIX will see the following trends occurring in other markets:
- Low risk appetite (“risk-off”) and a flight to quality
- Falling equities
- Reduction in yields (i.e. the benchmark risk free Government bond yield and swap rates)
- Increase in values of fixed rate bonds, particularly long dated bonds
- Increase in credit spreads (which is often offset by the fall in benchmark swap rates/yield curves for fixed rate bonds)
- Underperformance of floating rate notes versus fixed rate bonds given that FRNs are impacted by higher credit spreads but also see falling base rates such as the bank bill swap rate (BBSW)
- A reduction in liquidity and wider bid-offer spreads
All investors should regularly assess their portfolios to ensure they match their individual circumstances. Volatility is an important measure to consider in long term planning but also to monitor for assessing current market trends and potential changes to your portfolio, with the VIX being the most recognised volatility measure.