The so-called ” fear gauge” is looking low and that has some investors concerned. The matter at hand is complacency, or not worrying enough about the risks of investing.
The CBOE volatility index, or VIX, is known colloquially as the fear gauge. It measures the price that investors are willing to pay to buy insurance against a drop in the broad stock market.
“It gives you an idea of how much people will pay up for that protection,” says Russell Rhoads, director of education for CBOE’s Options Institute in Chicago. “The more concerned they are, the more it goes up in value.”
[See: 8 Times When You Should Sell a Stock.]
The more fear there is among investors, the higher the VIX tends to go as market participants get anxious that stock prices will become volatile. Less fear among investors leads to a lower VIX as investors see lower levels of volatility ahead in the market. That anticipation of more or less volatility is why the moniker “volatility index” is often used.
Lately, the cost of buying that insurance against a stock market drop has remained fairly low, indicating low levels of fear. Since the beginning of February, the VIX has not ventured above 13. That compares with a high of 28.43 in August 2015, which coincided with a stock market meltdown after the Chinese economy started to show serious signs of weakness.
The VIX was generally a lot higher in the latter half of the 1990s, frequently reading at least 20. Now it’s closer to 10.
“I call this environment a golden halo,” says Woody Dorsey, a behavioral market expert at Sentiment Timing. He says it’s an environment where investors believe “nothing can go wrong.”
“But as we know, eventually something does [go wrong],” he says and advises that investors should be cautious about stocks.
“We have reached that point where people have become absolutely convinced that any pullback in the market will be short-lived,” says Lance Roberts, chief investment strategist at Clarity Financial in Houston. “It’s certainly concerning.”
[See: 10 Skills the Best Investors Have.]
Such bullish optimism among investors is often typical during times of euphoria. We saw similar attitudes during the housing bubble when people believed that home prices would keep rising forever. Of course, eventually, house prices crashed.
And that’s the concern here, that some people are becoming too optimistic about stock prices.
The worry about overoptimism in the market has one strategist reminding investors to keep an eye on the long term.
“What we look at is clients’ need for cash,” says Jack Ablin, chief investment officer at BMO Private Bank in Chicago. “If you have cash needs [in] less than 10 years, then you need to invest in something other than equities.”
The reason for the longer term outlook is because stock prices can go down as well as up. If they go down, then there might not be enough value in the stocks to cover the expected cash costs by Ablin’s clients. Over the longer term, stocks have a higher chance of keeping their value or even gaining.
How to invest? The easiest way to deal with worries that investors are too complacent is to look at your own portfolio. The question to ask is simple: Do you have such a big allocation in stocks that the thought of a market drop will make you lose sleep? If you will lose sleep when the market falls, then you probably have too big an allocation of stocks.
The specific way to deal with that will be different based on different circumstances. But the following example should help.
[See: 7 of the Worst Stocks to Buy for 2017.]
Say you have an allocation of 80 percent of your portfolio in stocks (the rest in bonds) and the thought of a sustained market decline would cause you much mental discomfort. In that case, think about how you would feel if you had 60 percent in stocks. If that would mean an easier night’s sleep then sell some of your stock allocation and switch it into bonds, with the end result being that you have 60 percent stocks, 40 percent bonds.
That’s still considered a balanced portfolio which will grow over time, and will help you rest easy at night.
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Low Volatility Worries Some Investors originally appeared on usnews.com
