Equity markets bounced back after a tumultuous August and September. How much the rebound helped investors’ portfolios probably had a lot to do with how well they adapted to changes in volatility.

The October recovery saw the MSCI World Index, which tracks developed-market stocks, climb by about 8% as market risk receded. By the end of that month the VIX, an index that reflects the volatility implied by the pricing of US stock options, had fallen back below average.

Portfolios that focused too much on the VIX as a signal to raise or lower risk might have found it hard to add back equity exposure in time for the recovery. That’s because most of the rally happened early in October, when implied volatility had started to subside but was still elevated. A broader risk-aware approach (Display) probably would have called for less dramatic swings in equity exposure.

Don’t Fix on the VIX

The VIX can be a useful short-term volatility measure, but the index itself is pretty volatile. So, it makes sense to temper this “what’s happening now?” short-term view with an assessment of the medium- and longer-term time horizon.

It’s best to add an intermediate-term perspective to current readings, and to consider the influence of historical averages. This allows investors to capture the immediacy of markets, the prevailing risk regime and the tendency of indicators to slowly revert to normal over time.

This broader view told us risk probably wasn’t as high as the VIX suggested at either of its recent peaks. We also don’t think future volatility will be as calm as the VIX indicates today.

In portfolio terms, that perspective tends to translate into less vulnerability to trend-following and selling into distress at market troughs. It also requires less aggressive re-risking as markets are recovering and prices are rising. Overreactions to these market swings can be very costly.

Avoiding the Whipsaw

To get a sense of how much of a problem whipsawing can be, we can compare two portfolios. One focuses narrowly on the VIX to make equity-allocation decisions; the other uses a broader measure designed to avoid the classic market-timing mistake of selling low and buying high. Portfolios are most vulnerable to this misstep in a risk-on, risk-off period like the one we just saw.

The portfolio using only the VIX signal essentially calls for constant and often substantial equity-allocation changes, while the broader signal asks for more gradual changes (Display). These measured adjustments help keep portfolios from selling into market declines and re-risking after markets have calmed down and rallied. A longer-term view like this adds valuable perspective to asset-allocation decisions.

Numbers Matter…but So Does Judgment

As important as the numbers are in risk management, they don’t replace good judgment. Even robust quantitative measures can be influenced by short-run technical factors; investors need to analyze the source of market anxiety to determine if it’s well founded.

August was a good illustration. We suspected that the initial volatility spike might have been magnified by heavy selling from risk-managed strategies tied to the VIX. We didn’t think stalling emerging-market growth and declining commodity demand were as much of a spillover risk for developed economies as some investors might have first thought. These two insights told us that higher volatility would be temporary and not lasting. That’s in fact how the scenario played out.

Navigating volatility boils down to a deceptively simple notion: adapt, but don’t overreact. In practice, designing a sound risk-management approach is quite a bit more complex. But we think avoiding a myopic focus on short-term, systematic measures alone is a good start.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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