VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, an index that measures market uncertainty. It shows the implied volatility of options on securities in the S&P 500 index.

The greater the volatility of the options, the higher the index. A higher VIX indicates higher investor uncertainty and greater turbulence in the securities under option. The following chart shows the index over a four-year period from May 2004 to April 2008:

Figure 1 – The graph of implied volatility (VIX) from 2004 to 2008  

We can see that from late 2004 until early 2007, with a few episodic exceptions, this volatility index tended to stay in the 10% to 15% range.

Figure 2 – The American S&P 500 index from 2004 to 2008

If we compare the VIX chart to the S&P 500 graph for the same period, we see that while volatility remained in the range of 10% to 15%, the S&P 500 index showed a clear trend, in this case upward. From late 2004 until early 2007, the index rose about 40%, from 1,100 to about 1,500 points.

The same relationship can be seen between the VIX and, for instance, the Canadian S&P/TSX60 index.  It only requires a quick glance at the chart of this index to see a significant upward trend from late 2004 to early 2007: the index rose 60% from around 500 to 800 points.

Figure 3 – The Canadian S&P/TSX 60 from 2004 to 2008

We also see that beginning in early 2007, the VIX rises, reflecting renewed, profound market anxiety: we definitely leave 10%-15% range territory to reach historic levels two to three times higher than the previous average. At the same time, from the American and Canadian index charts we see that the market becomes strongly congested, with a range of about 300 points for the S&P 500 and 150 points for the S&P/TSX 60. Beginning in early 2007, therefore, the market changes mood and becomes erratic, at the same time as the VIX. What then is the best approach for investors to take?

For the past 60 years or so, there has existed in the academic financial world a hypothesis of the efficient market, with its three forms: semi-strong, strong and weak.

In the first form, share prices reflect all available public information, such as financial statements, financial analysts’ forecasts, etc. In the second form, prices discount all available public information, as in the first case, but also private information (such as insider information of corporate officers). Contrary to the first two forms, the weak-form efficient market hypothesis holds that prices follow a random course, and consequently past price behaviour is no indication of present or future behaviour.

If we apply these definitions to market index charts, we can say that the semi-strong and strong forms reflect price behaviour in clearly definable market trends, like the increase from late 2004 to early 2007, for instance. There is consensus among a large majority of investors on price direction.

Beginning in early 2007, however, the upward trend appears to have peaked for the moment, and price behaviour becomes erratic, with broad movement both down and up, in a clear demonstration of uncertainty. These movements reflect the fact that investors are disoriented, unable to find a balance between believing the economic news, which appears catastrophic, and hoping that the news is exaggerated. Older investors remember that experts have made terribly sombre predictions before, yet the anticipated problems later evaporated without consequence. Ten years ago, shivers ran through the financial world when the news predicted a global disaster because of contamination from the Asian interest rate crisis and a failure that shook the central banks: that of the gigantic and until-then prestigious Long-Term Capital Management hedge fund. Finally, several months later, it became clear that fears of a global crisis were largely unfounded, and that most analysts had failed to place the bad news in a more circumstantial perspective. 

The avalanche of news – sometimes in incomprehensible language – that has descended on us since last August on the crisis of confidence in the economy and finance has caused tremendous anxiety: will things improve or worsen? “The worst ills are those that never materialize,” said Samuel Johnson. Surely participating in the market under such conditions is a much greater challenge than when we are sure of the facts.

We could define the current situation as a classic case of the weak-form efficient market hypothesis: price behaviour is random.

Here, the only possible strategies are so-called mechanical strategies, which exclude any reasoning because we are confused and incapable of deciding when and how to act. The oldest and best-known such strategy is Dollar-cost averaging (DCA). Very simply put, this strategy consists of investing the same amount at regular intervals, regardless of the price. If the price is low when we buy, we necessarily get more shares than if the price were high. This is therefore a strategy for periods of congestion with high volatility.

Example: An investor has $9,000 that he would like to invest in ABC securities (a fictional symbol), initially at $25 per share. In our diagram, the security will fluctuate between a low of $10 and a high of $40 over time.
The investor has two strategies to choose from: invest the full amount by buying 360 ABC shares now at $25 and wait, or invest $1,000 in 40 shares and leave the rest of the money in his account. Then, in each period of, say, one month, two weeks or three months, for instance, invest another $1,000 in the same shares. In all, it would take nine periods. 

      Diagram – An example of the Dollar-cost averaging (DCA) strategy

Example Summary

In our example, the strategy has two advantages: if the investor had invested all his capital at once, he would have bought 360 shares at $25, and by period 9, would have neither made nor lost money. By applying the DCA strategy, he would have bought more shares with the same capital – 435 shares compared to 360 – and he would also have a healthy profit.

Our example also shows that the disadvantages are negligible: fewer dividends and, depending on the account structure, more commissions. But at the same time, the uninvested capital can earn interest.

Investors who wish to apply the DCA strategy systematically in all circumstances face two limitations: intuitively, in a rising market, return is lower than if the entire amount is invested initially. Shares that lend themselves to the strategy tend to be only those whose price/earnings ratio is relatively high for their industry, because their growth potential would appear to be compromised for a time and may even prove to be negative. One has to know how to select a security and set the investment frequency and interval ahead of time.

Our example shows that we can buy more shares than with a single investment. This would not be the case in a steadily-rising market.

There is a psychological advantage to the strategy: we are often reluctant to invest a large amount all at once in a single security; subdividing the investment into a number of fractions is easier to accept. In practice, we do not always have the full amount we would like to invest. This is the case, for instance, in an RRSP account with periodic contributions. In this case, the DCA strategy is worth considering even at times when volatility is not high.

To learn more about ETFs, see the DisnatUniversity tutorial on the subject at www.DisnatU.com/ETF

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Opinions expressed in the articles herein are those of the authors and do not necessarily reflect the views of Disnat.

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