What in the heck is the “VIX?”
The “VIX”, by definition it is a measure of volatility based on near term options pricing. Basically it’s The Fear Gauge. This makes sense because this renewed market volatility is creating fear among investors.
If you are fearful. If the financial news headlines makes you shiver and you’re full of anxiety; you have way too much allocated to “equities” (stocks, ETF’s or stock mutual funds).
The major asset classes are Equities (or stocks) and Fixed Income (Bonds and Cash). Financial Advisors help investors allocate among these and many other asset classes (International stocks, REIT’s, Buying Gold, Utilities, Preferred Stocks, Convertible Bonds, etc.) in an effort to “diversify” the investor’s portfolio and help mitigate risk. The idea is to spread the money around various asset classes to create diversification and Presto! You’re diversified and this lessons risks.
The truth of the matter is that this is a Global financial system. Buying international stocks for instance is a way to diversify currency risks, NOT equity risks. In today’s markets, everything is correlated. If a bank in Greece shuts down, it affects the US markets, the Japan Nikkei index, the stocks trading in India, Israel, and Bangladesh. Every stock market in every part of the world is affected.
For the longest time equities and bonds were negatively correlated, meaning they didn’t move in tandem. If stocks zagged, bonds zigged. The classic 60/40 stock/bond allocation was considered conservative (and to this day it is standard allocation among pension funds) due to this magic of negative correlation. Unfortunately bond yields are at all-time lows and have nowhere to move but UP. Not to get too complicated but bond yields and bond prices move in opposite directions. If bond yields move from 2.5% to 3.5% an investor holding bonds loses principal (…on paper, holding to maturity solves this problem of principal loss).
A properly diversified portfolio holds a smattering of stocks, bonds, cash, REIT’s, precious metals, preferred’s stocks, and emerging markets. The question is how does an investor allocate among the various asset classes? Most financial advisors use an investor’s AGE as a basis for asset allocations (younger investors hold more stocks, older investors hold more bonds for safety and income). I don’t agree with this methodology, even younger (20-something) investors can become very nervous and anxious in a market correction.
My belief is to allocate your assets based on your risk tolerance. Invest in equities only up to the point where market volatility doesn’t concern you. If this means only a 30% allocation to stocks helps you sleep at night, that should be your limit.
*Next post (Part II) will deal more in depth with allocating based on risk tolerance.