VIX, Volatility, and Investor Behavior

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For decades, investors had very few schools of thought for investment philosophies. Benjamin Graham’s value investment platform and EMH (efficient market hypothesis) were the most popular. But in recent years, a new school of thought known as behavioral finance has begun to take center stage.

This new model takes into account things like volatility and investor behaviors and patterns in order to predict stock movements. Understanding how other investors are trading can help you pinpoint trends and momentum plays in the market. But, like all things dependent on human activity, behavioral patterns aren’t foolproof.

The New Investment Philosophy

The classic EMH model has one glaring fault that investors have been picking at for years – it assumes that all investors are rational. But, as anyone with access to the internet can tell you, this is far from accurate.

Human beings don’t always invest in a rational manner. Many times, the same data is taken to mean wildly different things by analysts who believe they are interpreting the results correctly. A poor earnings report for a quarter may signal a company is headed down for one investor, while another sees it as an opportunity to buy the stock at a discount.

One way to measure investor sentiment is to look at what’s commonly referred to as Wall Street’s “fear” gauge, the VIX. This index measures volatility and can give you a good idea of the overall sentiment in the marketplace. Traditionally, a level of 15 has been the marker of average volatility, while 20 and over indicates higher volatility and, thus, higher risk.

But behavioral finance tells us that this indicator can actually mean something else at extreme highs and lows. When volatility is low, you might think it indicates a low level of risk in the markets. But what it actually means is that investors believe there is a low level of risk and might be complacent. In other words, it could be the calm before the storm.

The same thing happens when the VIX reading is extremely high. Investors may believe there is a lot of risk in the market, but savvy traders could use the volatility to find undervalued stocks at discounted prices.

While understanding investor mindsets can help steer you to profits, it’s best use is as a timing tool. Fundamental analysis remains the best and most accurate way of determining a stock’s real value. Regardless of other investors’ opinion of a company, its true strength can be determined by looking at the companies’ fundamentals, like earnings.

Behavioral finance helps to explain things like stocks with negative earnings and little growth making strong upside moves entirely on the basis of investor expectations or media coverage. Smart investors know how to tune out the noise and use uncertainty and volatility to their advantage.