While it might be difficult given that the memory of February's "volocaust" is still fresh in their minds, investors would be better served if they stopped using VIX as a proxy for market risk.
That's because, as Wall Street Journal columnist James Mackintosh makes clear in a piece published Monday, geopolitical risks have, over time, proved far more consequential to investment returns. But in the near-term, investors tend to discount them until crisis erupts.
Investors almost entirely ignored what many thought was a rising prospect of nuclear war on the Korean Peninsula last year, and they have also pretty much ignored the welcome prospect in the past week of peace breaking out. Investors realize they have no idea what the chance of war is, and aren’t even any good at assessing whether it has gone up or down.
By contrast, February’s "volmageddon" had a direct impact on stock prices. The Cboe Volatility Index and its equivalents in other markets are treated by many investors, academics and policy makers as a proxy for risk generally.
This is a mistake.
But of course, over the long term, the risk of nuclear armageddon and its impact on financial markets (to say nothing of civilization) is paramount. So the fact that this isn't factored into risk models is patently ridiculous, Mackintosh suggests.
Looking back over the history of the 20th century, where communist revolutions and world wars led to massive investor losses, the stupidity of markets ignoring geopolitical trends becomes even more apparent, Mackintosh says. After all, if you owned a casino in Cuba just before the revolution, you lost everything.
There's a reason for this, of course, Mackintosh says. It's difficult to predict geopolitical developments - who would've predicted a year ago that President Trump would be preparing for a peace summit with North Korea leader Kim Jong Un?
Investors who owned Russian stocks in 1917 or Chinese stocks in 1949 lost everything. London Business School market historians Elroy Dimson, Paul Marsh and Mike Staunton calculate that shares in Austria—which lost two wars and an empire—lost money after inflation over 97 years, even when counting dividends. Shareholders in Belgium, Germany, Italy, France and Japan were down in real terms for more than half a century, as were Spanish investors, who endured a destructive civil war and dictatorship.
Yet, can any of this guide your investments? There is good reason to ignore most of the twists and turns of geopolitics: It is just too hard to assess, as Korea shows. Five months ago, North Korea tested a missile capable of hitting U.S. cities, and talk was of a U.S. pre-emptive strike. On Friday, Kim Jong Un became the first North Korean dictator to visit the south, and the two sides agreed they would sign a proper peace treaty by the end of the...