It Pays to Stay Risk Averse Despite Strong Market Returns


As the stock market roars on, skeptics might take money off the table and invest in more value oriented assets. More often however, fear of missing out on future gains along with recently strong returns keeps people invested in the market and seeking out speculative opportunities. As investors become greedy and shift their investments into riskier asset classes chasing larger returns, they expose themselves to tremendous downside risk.

We can examine this phenomenon through a recent example of the inverse VIX ETF (XIV). XIV went higher as volatility went lower. For the past several years the stock market had been experiencing low volatility and it seemed as though it would stay this way. Easy money was being made by investing in inverse VIX ETFs and speculators began to pile in. It seemed as though volatility could only go down, and inverse VIX investors were making money hand over fist with their speculative allocation. People were well aware that the historically low volatility wouldn’t last, but they couldn’t help themselves from ignoring the risk and investing anyways, hoping that they would be able to sell out in time. The XIV chart showed the following:

Over 480% returns in little over two years. It is no wonder that people were eager to put their money into this seemingly unflappable investment. Two years of absolutely tremendous returns, previously inaccessible to the common investor, but now available because of the prevalence of ETFs. Those who saw this vehicle and chose not to invest probably heard of the excessive returns others were experiencing and gritted their teeth as they stayed disciplined, watching others’ returns soar past their own. As you may guess, this is not the whole story. In early February of 2018, the market experienced a shock and in a matter of 2 days the chart for the inverse VIX appeared as it does below.

Years of euphoric returns wiped out in the matter of a few days. It is easy to see recently spectacular returns and become caught up in the fear of missing out despite the risk, bending your investment goals around your desire to speculate in the market. Even if you bought XIV at the previous two year low around $18, you would still be down 64%. An investor may understand the risks involved, but it becomes very easy to convince yourself that you can get out at the top, before it comes crashing down. The Warren Buffett wisdom to be “fearful when others are greedy, and greedy when others are fearful” finds no better case study than what has happened with XIV.

The example here is demonstrative of an even greater principle that plays out again and again in market history; what works in the short-run may not benefit you in the long run. Protecting your principal is one of the most important things you can do as an investor. The power of compounding returns is exponentially reduced as principal is reduced.

While it may be tempting to chase asset classes that have had strong recent returns, there is no such thing as a guarantee (or as Dave Clayman calls it, the “g” word) when it comes to investing. Volatility works in both ways, towards the upside and the downside. What works for years because of irrationality can all be erased in a matter of days.

Do not bend your investing goals to match a speculative asset, match your prospective assets to your investment goals.

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