Listen to the financial news, and you’ll often hear reference to “the VIX.” But what exactly is the VIX, and how important is it?

The VIX index is intended to be a measure of investor sentiment. For that reason, it’s often referred to as the market’s “fear gauge.”

How can investor sentiment be measured? While the math is complex, it’s based on a straightforward principle: When investors get nervous, they look for ways to protect their portfolios and are sometimes even willing to pay for that protection. This was the insight that led to the initial development of the VIX back in 1989.

Two finance professors, Menachem Brenner and Dan Galai, observed that stock options—and specifically, the prices of those options—provided a sort of X-Ray into investors’ feelings. That’s because certain options, known as “put” options, are designed to protect portfolios from losses. They’re like insurance. So when demand for put options increases, and as a result, pushes up the prices of those options, that’s an indication that investors are feeling more nervous. On the other hand, during periods when markets are rising and investors are feeling less nervous, put options will fall in price. During those periods, “call” options, which allow investors to magnify their gains in rising markets, will go up in price.

The relative prices of these two types of options can tell us a lot about investors’ mindset, and that’s the basis of the VIX. In very simple terms, when put option prices are rising, the VIX rises. And when put option prices are falling, the VIX falls. A higher VIX reading thus means investors are becoming more fearful.

Because of its function as a sentiment gauge, market commentators like to talk about the VIX, especially when it’s rising. But I’m not sure we should put too much stock in it. That’s for two reasons.

First, the VIX is fundamentally limited because it’s only able to measure current investor sentiment. It doesn’t know anything about what will happen in the future. Consider how the VIX behaved during some significant market events over the past 20 years.

In August 2008, the VIX was at a relatively low level, right around 20. It seemed to be indicating calm seas. But just a month later, Lehman Brothers went into bankruptcy, and the stock market began to fall, ultimately dropping 50%. The VIX did eventually spike up in response to this crisis, rising all the way to 80—a very high reading—but by that point, it was too late. It was effectively reporting yesterday’s news.

The VIX has been similarly unhelpful during other crises. In the spring of 2020, when the market dropped more than 30%, fear levels were running high, and the VIX spiked up to 82. But with the benefit of hindsight, we can see that the VIX wasn’t communicating anything useful. That’s because the spring of 2020 would have been an ideal time to buy. Between the VIX’s peak on March 16 and the end of that year, the S&P 500 rose 57%. But the VIX provided no hint that this rally was coming. Instead, it was signaling that it was a time to be fearful.

Nearly the same sequence of events occurred in 2025. In April, when investor worries were running high over the White House’s new tariff policies, the VIX spiked up, topping 50 on April 8. But that also would have been an ideal time to buy. A short time later, the White House changed course on tariffs, and the market rebounded, gaining 37% through the end of the year.

Why is the VIX such a poor predictor? In his book Finance for Normal People, Meir Statman provides one answer, describing how investors are susceptible to recency bias. He cites a Gallup survey that asked investors, “Do you think that now is a good time to invest in financial markets?” Almost invariably, investors answered “yes” when markets had been rising. In February 2000, for example, 78% of those surveyed responded positively—just a month before the market fell into a multi-year decline. The problem is that our minds’ are prone to extrapolating from current conditions. And since the VIX simply mimics investors’ thinking, it too just extrapolates. The VIX has no idea when the market is about to reverse course.

Despite this flaw, however, you might wonder if the VIX would nonetheless be useful as a portfolio hedge. In other words, even if the effect is delayed, the VIX seems like it might be helpful if it goes up when the market is going down, and vice versa.

In The Four Pillars of Investing, William Bernstein looks at this question. He examines a popular ETF (ticker: VXX) that tracks the VIX index. On the surface, this looks like an effective way to protect a portfolio. In the first three months of 2020, for example, when Covid arrived, and the stock market began to drop, this ETF rose more than 200%. But that was one narrow time period. Other periods were punishing for VXX. Bernstein points to 2010-2011, when the S&P 500 rose about 8.5% per year, on average. What did VXX do during that period? You might expect that it would have fallen proportionately. But instead it cratered, losing 74% of its value. Bernstein asks wryly, “You didn’t expect that someone would sell you bear market insurance for free, did you?”

That, unfortunately, is the issue. Because of the way it’s constructed, the VIX doesn’t work as a perfect offset to the stock market. That’s why, in my view, investors are best served by a much simpler portfolio structure, consisting of stocks and primarily short-term Treasury bonds. While this combination isn’t flawless, it’s delivered far less volatile results over time than any strategy built around the VIX.

Like many things in finance, the VIX is interesting, but ultimately not of much practical use.

Best wishes for the weekend.​