'Fear Gauge' Spikes, Then Falls. How That Affects Your Stocks

The Cboe Volatility Index (VIX), often referred to as Wall Street’s "fear gauge," has seen a dramatic surge, more than doubling in just 16 trading sessions from mid-February through last week. This sharp increase pushed the VIX above 92% of its daily readings since 1990.

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Many contrarian investors view a high VIX as a bullish signal, particularly when the index experiences a rapid spike like it has recently. The logic behind this perspective is that extreme fear in the market can indicate a potential bottom, leading to future gains. However, history suggests that higher volatility is not necessarily beneficial for stock market performance. In fact, stocks tend to perform better when volatility remains low.

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Given this historical trend, investors might achieve stronger returns and greater peace of mind by taking a different approach—maintaining a higher stock allocation when the VIX is low rather than reacting to high volatility spikes.

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A Strategy for Managing Volatility

This idea is supported by research conducted by finance professors Alan Moreira from the University of Rochester and Tyler Muir from UCLA. In their study, Volatility-Managed Portfolios, they developed a market-timing strategy that capitalizes on the market’s tendency to deliver stronger performance with reduced risk when volatility remains subdued.

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A simplified way to implement their strategy involves two key steps:

1. Establish a target equity allocation based on a mid-range VIX level.
2. Adjust your equity exposure each month by multiplying your target allocation by the ratio of your VIX baseline to the VIX closing level from the previous month.

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For example, suppose your target stock allocation is 60%, with the remaining 40% in a money-market fund. If you set the middle-of-the-road VIX level at its historical median of 17.61, you can determine your allocation adjustments based on recent VIX readings.

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At the end of February, the VIX stood at 19.63. Applying the formula, your equity exposure for March would be reduced to 53.8% (calculated as 60% times the ratio of 17.61 to 19.63). If the VIX remains elevated at current levels by the end of March, your allocation for April would drop further to 47.6%.

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Since its inception in 1990, the VIX-based strategy has delivered significantly better risk-adjusted returns compared to a traditional buy-and-hold approach. The strategy’s Sharpe Ratio, a key measure of risk-adjusted performance, was 0.99, compared to 0.78 for the broader market. Additionally, the strategy has continued to outperform even in real-time market conditions, demonstrating its practical effectiveness beyond academic research.

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Contrarians aren't entirely mistaken in their belief that the market can recover when the VIX is high. However, they often fail to account for the elevated volatility that accompanies such conditions. While returns may be higher following periods of extreme fear, the corresponding market swings tend to be much more pronounced, making for a rougher ride.

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A deeper look at historical data underscores this point. When analyzing trading days since 1990, splitting them into four quartiles based on VIX readings, a clear pattern emerges. The stock market’s average return for the month following the highest 25% of VIX readings is nearly double that of the lowest quartile. However, the standard deviation of returns is nearly three times greater for the highest VIX quartile, meaning the gains come with significantly more risk. As a result, the return-to-volatility ratio is far more favorable when the VIX is low rather than high.

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What This Means for Investors Now

With the VIX currently sitting in the upper 25% of its historical range, investors should brace for a volatile period ahead. Even if the stock market manages to post gains in the coming month, the ride is likely to be turbulent. Those who prefer a smoother path to returns may find greater success in maintaining higher stock exposure when volatility is low, rather than attempting to capitalize on market swings during periods of heightened fear.

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