Volatility (VIX): A Misleading Measure Of Risk

Chris Cole of Artemis Capital has a broader definition of volatility – “(volatility) is the difference in the world as we imagine it to be and the world that actually exists.” Think about his quote carefully before reading on.

In the investment sphere, Cole’s statement can be boiled down to the contrast between the consensus mindset investors hold to explain the current state of economic activity, fundamentals, market valuations and implied risks versus the reality encapsulated by those metrics. While no one can quantify “the reality”, the wider one perceives the difference between implied volatility and reality, the greater the opportunity present in the market.

Since the 2008 crisis, and especially over the last three years, implied volatility has been abnormally low more often than not. In other words, investors believe the risks of a significant downdraft in stock prices is relatively minimal. This by no mean indicates that the actual risks investors face have decreased per se, just that the financial gauges constructed on investor positioning claim that to be the case.

The graph below plots implied volatility via the VIX Volatility Index (INDEXCBOE:VIX) for the S&P 500 Index (INDEXSP:.INX) since 1990.

Source: Michael Lebowitz