“What are we going to do when the market crashes?”

It was one of the first conversations I had while at a conference, but it wasn’t the last time this topic came up. In fact, there were many more attendees who asked the exact same thing.

When asked this question, I had to give an impromptu answer. As a result, the eyes of most attendees clouded over as I was immersed in market dynamics and current market trends.

That’s not what they wanted to know.

What they were really concerned about was not how I am handling the next crash within a particular service, but how they and others could prevent a crash like the one we saw in 2008 when it happens again.

Today, I’ll give you the best and most conservative way to do it by following a simple indicator: volatility.

Specifically, I’m talking about the CBOE S&P 500 Volatility Index (VIX), also known as the fear index.

Basically, this index measures the implied volatility of options on the S&P 500 Index. It is called the “fear index” because the index rises when investors rush to buy S&P 500 put options as a means of protection against crashes. The higher the index rises, the more worried investors are about a market crash.

This concept holds true in practice based on data showing the VIX rises in times of panic when the S&P 500 crashes.

Watching the VIX can be a simple means of keeping your wealth out of harm’s way, like in the global recession of 2008. But it can also help you grow your portfolio as markets recover. Let me explain…

Throw the VIX in the mix

As with any type of index, different VIX levels tell us different things about the market – this is how we are going to determine when to invest and when not to.

VIX lows currently range from 10 to 13. While that is not important for our current topic, it will help you understand that any VIX reading from single digits to teens means investors are not scared at all.

Once the VIX breaks above 20, the index indicates that investors are worried about the market. They might even be taking a little money off the table right now.

When the VIX is above 30, the S&P 500 has likely experienced a correction (at least a 20% drop) and investors start to panic.

When the VIX is significantly beyond 30, investors definitely panic and the S&P 500 is about to crash. At this point, investors are selling everything in their portfolios just to stop the bleeding. They no longer care at what price they come out. They just want out. That type of panic selling tends to feed on itself, causing the market to spiral down over an extended period of time.

To avoid a crash, I ran a simple backtesting strategy where I would buy the S&P 500 only when the VIX was below 25, meaning investors weren’t in full panic mode yet. Then, once the VIX crossed above 25, you would sell and cash.

Results from the last 15 years show that following this strategy would have generated an overall return of 70%. However, the S&P 500, followed by the SPDR S&P 500 ETF (NYSE Arca: SPY), is up 85% over the past 15 years, underperforming by 15 percentage points.

At first, this seems like a bad investment strategy. But the underperformance is mainly due to the fact that it takes a while for the VIX to settle back below 25 after a spike in volatility.

However, the benefits of using an indicator like this is that you miss out on the worst of stock market crashes. For example, by following this strategy and exiting once the VIX crosses 25, you would have gone into cash on September 12, 2008, just before a 45% drop in the stock market.

So even though your overall return was lower, your risk exposure was much lower. Avoiding that 45% decline makes this strategy worthwhile by letting you sleep better at night knowing you missed the worst.

The only thing we have to fear

While my answer to the attendee’s question was a bit long, the bottom line is that if you’re worried about a market crash that matches or exceeds that of 2008, the VIX is the indicator to watch.

Just move into cash as it rises above 25, and look to come back once you drop below that level again.