The VIX Index measures expected stock market volatility in the month ahead based on option prices. Generally speaking, when investors believe the stock market is likely to make a big move, options prices rise. Low volatility markets are marked by lower option prices. The current VIX reading of about 12 is in the lower end of the range – realized historical volatility has averaged about 16 since the 1960s based on S&P 500 annual returns published by Ibbotson Associates.

So what do the numbers mean? The historical average of 16 since the 1960s means that 68% of the years had returns within 16 percentage points – one standard deviation – of the average annual return for the period. About 95% of the annual returns were within two standard deviations of the average; 99% were within three standard deviations.

Note for the gotcha crowd: We know that stock market returns are not normally distributed, but for this discussion it provides a reasonable approximation.

Now let’s talk about why low volatility markets can be bad for active investors. Suppose you have a strategy that can capture 15% of the ups and downs of the market. What if there are no ups and downs? Then you just captured 15% of zero, or nothing. In a high volatility market with big zigs and zags and the same capture ratio, your strategy can be expected to do a lot better.

As it turns out, our strategy does not do as well in low volatility markets, just as expected. But over a market cycle, complete with periods of both low and high volatility, we believe we are likely to do well. The event is more like a marathon than a sprint.

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