Trending
Written by: Matt Lloyd | Advisor Asset Management
The ancient Chinese proverb, “may you live in interesting times,” should perhaps have an addendum to it: “may you survive interesting times.” Recency bias almost necessitates that the current state of “interesting times” is “always” more challenging than previous periods, however in retrospect it is often the case that it only “felt” more difficult. While it is nearly impossible to have a lucid retrospect on relative difficulties, what it does equate itself to is that we perhaps forget the difficulty of past times because they were eventually resolved, and we tend to catastrophize the future. “That which doesn’t kill you, makes you stronger” has now moved to, “That which doesn’t kill you only makes you more paranoid.”
As we look at some of the historical measurements in the markets from concentration and ownership — accounting for a normalization of interest rates to historical norms — it is easy to get caught up in a binary approach to investing. Risk-on or risk-off seems to be a natural byproduct of the risk aversion on investors’ minds. However, there are often more lucid solutions when we take a micro view of a macro situation.
When we look at volatility, it is one of the more intricate and subjective measures as it pertains to the individual investor. One broad and accepted measure is the VIX — a measurement from the CBOE (Chicago Board Options Exchange) that is an expected movement in the next 30 days derived from prices on options on the S&P 500. These options are measured from 23–37 days to arrive at the 30-day expectation. If the markets had not gone under a mass transformation, this indicator may be more useful as a standalone. However, with the onset of single-day option expiration that now is estimated to be 40–50% of all expirations, it now skews a bit of the validity of the VIX.
The following chart from MarketWatch and DATAREK details the difference between the VIX and S&P 500 price volatility. What one notices is that in 2022 a large difference exhibited itself for a longer period than when we monitored this gap in the past. If you haven’t guessed by now, Single-Day Option Expiration was introduced in 2022.
Source: MarketWatch and DATAREK | Past performance is not indicative of future results.
So, while the longer period of option volatility in the VIX has been more subdued than most expect with their perceived volatile times, the daily option expiration helps explain a bit of this conundrum. The realized S&P 500 volatility relative to the VIX is relaying the same.
What we saw here recently is that the VIX had spikes in the latter half of 2024 and was quickly met with subdued levels.
We think that the recent trends of spikes in volatility followed by subdued levels will continue in 2025. As such, we should look at two very different ways that may work in this environment; both are challenging but for two different reasons.
According to one analysis by Sentiment Trader that looked at spikes of the VIX above 20 and then below 14 (much like we saw several times in latter half of 2024), the returns on the S&P 500 since 1991 was seen 26 times. What was astonishing was that 12 months later the S&P 500 was up 96% of the time, with a median return of 14.5%. This coincides with an annualized price return of the S&P 500 over that same time frame of 8.89% (9.75% total return). So, at the moments of the biggest shocks, an investor was paid to invest. However, the difficulty psychologically to do this can be met with the opportunity to engage in a portion of investments hedged for downside.
We believe your first step is to minimize these volatile times and have a much longer timeframe for your investments and then attempt to ride out the increased movements in either direction. This takes either a level of disregard or pulling a Rip Van Winkle and take a break away from the noise. Disregarding is not being obliviousness to material facts, but rather compartmentalizing them and focusing on the long-term goal. This option also mandates one is invested across a myriad of assets that have relative low correlation to protect a bit on the downside.
The other option is to look at some form of risk protection while still garnering some form of the upside. This upside will be limited to help in hedging the downside and can be achieved in the form of participation in upside to a limit or garnering a coupon based on the underlying levels. With some protection of assets to a certain degree and limited upside, an investor can try to focus on other areas to complement or amplify other investments to better meet their long-term goals.
This is a form of a psychological barbell in that long-term assets on one side are meant to help achieve the long-term goals, while the other side of the barbell is shorter term to assist in balancing the risk/reward of the investment. Taking a portion of the psychological blocks to invest at the more challenging times can be offset with a bit of a life preserver in choppy water by implementing some principal protection.
Related: Mastering Funnel Asset Development for Client Conversion