How S&P500 Performs In Different VIX Regimes
(7 min read)
‘Be water my friend.’ Elegant, insightful, evocative, and one of the best-known quotes of perhaps the greatest martial artist of all time, Bruce Lee. But is it an appropriate start for a research piece examining the historical relationship between performance and volatility over the last 30 years? I think so, and by the end of this piece you’ll see why. As an investor you will have to deal, or had better make your peace, with volatility. It’s ever present, mostly in a dormant (even docile) state, just waiting to unleash its ferocity – forcing its consequences on the discerning investor when least expected. Lee’s advice is about adopting flexibility, and it might just help you navigate markets while using the predictive power of volatility as a helping hand rather than a foe to inevitably fight.
With stats, you must know the right questions to obtain meaningful answers. If you get the answer ‘42’, you had better already know the question. Like every good finance teacher, I ferociously preach to my students that volatility eats performance. Fine. But how does volatility do that? Are there any pointers, mechanics or divine insights that reveal when it might be prudent to invest, divest or crack open a Cherry Diet Coke and do nothing? I do not know. The question of ‘how’ volatility hits is probably answerable via analysis of market participants’ motivations and their deepest and darkest desires/fears. So, clearly, it falls within in the field of behavioural finance. But let’s not open that can of worms. The question I can ask, and answer, is the following: what happened when volatility did hit the market?
We’re going to analyse the relationship between the performance of the S&P 500 and the implied volatility of the S&P 500 represented through the VIX Index over a period of 30 years. As the S&P 500 represents the biggest equity market in the world, it appears to be a good proxy for average equity returns. The VIX Index will be the proxy for ‘expected market volatility’, thereby measuring the expectations of option traders about the future volatility of the S&P based on the pricing for ‘at the money’ options with a maturity of (roughly) one month.
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