Portfolio managers, analysts and financial advisors face a difficult task as high volatility and increasing geopolitical uncertainty turn markets on their head. You ask: Should I price adjust, reduce risk, or buy the dip?
While the instinct is usually to scale back risk, traditional financial theory suggests that investors needs to be rewarded for embracing uncertainty and remaining patient. However, theory and practice don’t all the time agree, especially relating to high-stakes decisions.
Market participants often depend on two widely used indicators when making decisions: Cboe Volatility Index (VIX) and the Index of economic policy uncertainty (EPU). However, it’s crucial to know the style of uncertainty you’re coping with, as misinterpreting these signals will be costly.
VIX and EPU are sometimes treated as interchangeable stress signals. They should not be. The VIX reflects market fears while the EPU tracks broader political divides. Confusing these two aspects can result in systematic errors: either being overly cautious when political uncertainty is high but markets are calm, or not reacting quickly when real fear arises. Misinterpreting these indicators can result in poor timing and missed opportunities, ultimately impacting returns.
The key query to ask is whether or not the uncertainty is attributable to market fear or general political confusion, each of which has different implications for risk, timing and portfolio positioning. Analysis of 35 years of knowledge shows that VIX and EPU exhibit different dimensions of unpredictability, with significant consequences for portfolio risk.
To examine how these differences play out in practice, I examine how each indicator predicts future stock returns in five different systems.
