Investment Planning: fear index and your asset allocation

Recent world events (China, banking regulations, Haiti, etc.), and corresponding market moves, have lead investors to become concerned about US stocks. The VIX index, also known as “the fear index”, is about as low as it was when Lehman Brothers collapsed in 2008 – a very low number.

Is this indicator rational and should act or should you continue to stick to your long-term investment strategy, and your asset allocation?

First, on volatility, there are hedges that some can buy but many are currently over-priced. That is, you can attempt to replicate the VIX Index and benefit from its contrary motion against the stock market as a form of “portfolio insurance”. However, because so many investors are concerned, they have over-bought this index, or its components, so it is not favorably priced, making this a bad time to buy.

Second, on stocks and ultimately on your asset allocation, does the index still tell you that you need to sell stocks? If you did, you always have the timing issue of when to buy back in (see the quotation below). Also, the fear index could, in fact, be a contrary indicator, indicating that you should not sell, just as when individual investors buy or sell, you should sell or buy.

Third, the worry is that the recent upswing means that stocks are over-priced now. However, the P/E ratio is neither as high as 2000 nor as low as the long-term average of 18. So the index does not necessarily sound a warning bell for mass sale of stocks.

A better response for arguing that you should adhere to your allocation is summarized by John Coumarianos, who is a mutual fund analyst with Morningstar: “Investors tend to time their allocation shifts poorly, doing themselves much harm along the way. That’s largely because they make such moves based on emotion rather than hard facts. For example, many investors abandoned stocks at the depth of the crisis in 2008, missing the big comeback in 2009. Our statistics on Investor Returns are grim. They prove that most investors do an awful job of timing the market, consistently selling low and buying high.”

He goes on to argue that you need to rely on mutual fund and other investment managers to go into cash when appropriate and then move back into stocks, based on their expertise and analysis, which is totally independent of the fear index.

As I have often said, having a long-term strategy and sticking to it is the key to achieving good returns over time. This often requires ignoring what others say, what the press or information like the fear index says, and your own sense of anxiety. A good portfolio will have both ups and downs, but it will work for you if you let it.