Why you don't need to fear market volatility around the election

Newer investors may worry about how much the markets move around during election season.

Ivan S | Twenty20

When Alexander Pope wrote, "A little learning is a dangerous thing," he didn't mean don't educate yourself: He meant be careful, because when you get into a new subject, your newfound understanding can lead you to make decisions based on partial knowledge. Those new to investing, for example, might get spooked by their introduction to volatility, or just how much the markets can move around.

Even in an ordinary year, it can be dizzying to see those jagged peaks and valleys on a stock chart. And your worries might be compounded in a year like this one, roiled by the uncertainty that surrounds the upcoming presidential election and exacerbated by a global pandemic that seems to have America's economy at its mercy. 

The best way to allay any concern over bumpiness in the market, though, is to face that fear and know what it really means. Here's a closer look at market volatility: How it's measured, where it comes from, and what experts say is most important to keep in mind.

The volatility index (VIX): How it's calculated and what it measures

To get a handle on volatility, let's look at a specific index that measures it: The Cboe Volatility Index, also known as the VIX. As defined by the Cboe (the Chicago Board Options Exchange), the VIX is a real-time measure of how volatile investors expect the market to be over the following 30 days.

The number is calculated based on real-time prices of S&P 500 Index call and put options, which are financial instruments that let you name your buying (call) or selling (put) price in advance, with the option but not the obligation to execute that trade by the expiration date. In the case of the S&P 500 Index, options expire 30 days after the day the option is executed.

The more "nervous" the market is, the higher the VIX. For example, on March 12, 2020, now known as Black Thursday, the VIX at the end of the trading day was 75.47. On August 18, when the S&P saw its highest-ever closing, the VIX was 21.51. 

The VIX, as the Cboe rightly says, is "one of the most recognized measures of volatility."  Investors pay close attention to the VIX even if they're not interested in options because it has an affect on the ordinary stocks you might have in your mutual fund.

"When the VIX goes up, it triggers selling on index funds and makes the S&P drop," says behavioral finance expert Jamie Cox. "It doesn't mean the stocks are worth less, it just means the index falls."

How the VIX reacts to presidential elections

It's normal for the VIX to be high surrounding a presidential election, from about a month before through the end of December, says Cox. "It's like test anxiety. You study and you're like, 'The test is going to be horrible' and then the test is over and the test anxiety goes away. It's the same with elections. The election occurs on defined dates. You know who the person in power will be." That's why the VIX tends to even out by time of the winner's inauguration in January. 

If you look at the VIX right before and after an election, you'll see that the VIX tends to go a bit wild and then flatten out. Here are two of the most controversial elections in recent memory: George W. Bush in 2000 and Donald Trump in 2016. Even with the chads in the ballots and other surprises, the VIX calmed down a few months after the election.

Here's a chart showing the VIX three months before and three months after the close George W. Bush victory in 2000.

And this chart shows Trump's surprise 2016 victory.

Cboe Volatility Index, 3 months before and after 2016 election
kiersten schmidt/grow Ycharts

Will a Trump or Biden victory calm markets? The answer 'is way less important than people think'

"Companies adjust to whatever the president's policies are, whether it's higher or lower taxes or trade wars. The good companies just deal with whatever the new rules are," says Cox. So the winner of this election "is way less important than people think."

And you can make investment decisions to take advantage of an elevated VIX, says Cox. "If the VIX is really high it means markets are likely to be lower in the near future, it's a good time to buy and a good time to rebalance your portfolio." A high VIX signifies that "markets are really far away from their normal trading levels," he adds, meaning that investors can find bargains during times of high volatility. 

"A high VIX right now means that we're in the storm before the calm," Cox says. Staying the course and avoiding a sell-off will suit most long-term investors. And if you are thinking of entering the market, this could actually be a great time.

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