Investing can be an emotional business.
When stocks are soaring, greed can take over and create the temptation to buy and make more money. When stocks fall, fear can set in and create the temptation to reduce losses and sell.
Most financial experts will advise investors to stay the course during periods of market volatility, remain invested and don’t try to “time” the market — buy at the low and sell at the high — because no one knows for sure when those lows and highs will come.
Is it possible for investors to make their emotions a manageable part of the investment process? Jack Ablin, chief financial officer of Harris Private Bank, believes it is.
“Being able to rely on a process that addresses the risk and opportunities that emotion creates in the financial markets during times of turbulence is an investor with an edge,” Ablin wrote in his book, Reading Minds and Markets: Minimizing Risk and Maximizing Returns in a Volatile Global Marketplace. “Being able to monitor the market’s emotional swings, you should be able to avoid being caught by either extremes of greed or fear.”
One of the first ways for investors to manage their emotions is to find out what other investors are feeling about the market.
There are a couple of ways to do this.
The Chicago Board Option Exchange VIX Index measures the volatility of stocks in the S&P 500 over the coming 30 days. Specifically, it measures the perception investors have about options on the index. Often referred to as the “investor fear gauge,” it has become known as the premier barometer of investor sentiment and market volatility.
There are three variations of volatility indexes. The VIX tracks the S&P 500, the VXN tracks the Nasdaq 100 and the VXD tracks the Dow Jones Industrial Average.
“The lower market volatility is, as measured by VIX, the more likely investors are to be complacent,” said Ablin. “The reverse is also true: when volatility spikes higher, investors tend to be more nervous and wary of committing their capital to what they may view as a riskier asset class.”
In a study of VIX over many years, Ablin found that the greater the volatility, the higher were the returns in the market.
High volatility periods were followed by average monthly returns of 6.3 per cent for S&P 500 stocks. In contrast, low volatility periods were followed by average returns of only 5.4 per cent over the following six months.
Very recently, Canada got its first tangible measure of volatility when the Montreal Stock Exchange introduced MVX, an index measuring the expectation of relative stock market volatility over the next month.
Another indicator is the New York Stock Exchange short interest ratio.
Short selling refers to the practice of borrowing stock and selling it in expectation of repurchasing it at a lower price in the future and getting a profit from a difference in the two prices.
Short selling is a risky investment strategy because the loss theoretically can be infinite.
The NYSE tracks how much short selling is going on in the stocks it lists and each month discloses stocks with the largest short interest ratio. In Canada, TMX monitors and reports information on short trading and the top 20 short positions in the market.
“A big change in the short interest ratio can correspond to a shift in investor sentiment and foreshadow a change in the market’s direction,” Ablin said. “The more short-selling going on, the more nervous investors are likely to be.”
Regardless of volatility measurement tools, Patricia Lovett-Reid, senior vice-president at TD Waterhouse, says investors still have to come to terms with the amount of risk they are willing to accept and return to the principle of asset allocation — investing over different markets and asset classes to maximize potential returns and minimize risk.
Talbot Boggs is a Toronto-based business communications professional who has worked with national news organizations, magazines and corporations in the finance, retail, manufacturing and other industrial sectors. He can be contacted at email@example.com.