Volatility? Don't bet on it

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Betting that markets will be "volatile" is like betting the weather will be partly cloudy. It's a smart-sounding strategy that doesn't mean much.

Listen to market strategists and a word that comes up a lot these days is "volatility." Outlook for 2016? "More volatility ahead." Buy these stock market dips? "Yes, but there could be more volatility."

This isn't new. It's been going on for years. And it's rarely useful information for investors.

That's partly because the term "volatility" could describe anything from stock prices rapidly fluctuating--which, by their very nature, they do--to a specific move higher in the market's best-known volatility gauge, the VIX.

Most use the term volatility in a broad enough way to suggest either, or both, of the above. That not only leaves them plenty of wiggle room for whatever actually takes place in the market, it also sounds like wise, prudent advice. The trouble is, it doesn't actually help investors that much in determining whether to invest in a given security, or index, at a given price.

Off the Charts: Examine the VIX
Off the Charts: Examine the VIX   

And when specifically recommending that investors buy or sell the VIX, the advice is rarely much better.

That's because the VIX itself largely tracks the stock market. It often trades at a lower level when the market is "boring," or gradually drifting up (reminiscent of the old Wall Street saying to "never short a dull tape"). It tends to spike when there are panicky market sell-offs, which by their nature almost no one ever sees coming. So timing the VIX itself is as difficult as timing the market.

Consider recent history: after the VIX spiked in late 2011, amid the U.S. credit-rating downgrade and European debt turmoil, "Just about everybody on Wall Street" thought volatility was "here to stay." By the following June, bets that the VIX was going higher reached record levels, with at least one observer warning they were reaching "bubble levels."

Instead of spiking, volatility swooned, ultimately falling to decade-low levels in the summer of 2014.

What about holding the VIX as a hedge against panicky market sell-offs?

Unfortunately, as Robert Whaley has observed, the most popular of these exchange-traded products "are not suitable for buy-and-hold investors because they are virtually guaranteed to lose money over time."

Since first coming to market in 2009, "they have chalked up aggregate losses in the billions of dollars," he said.

Mr. Whaley ought to know. He helped create the VIX itself for the Chicago Board Options Exchange back in 1993. And it remains to be seen whether the next generation of volatility products will solve existing problems such as high fees, trading commissions on derivatives, rollover costs, and imprecise tracking of the underlying index.

Beyond that, whether holding the VIX long-term as a hedge is actually profitable will still be the subject of much debate.

As MKM Partners recently noted, the behavior of the VIX itself changes over time. For instance, although a higher-volatility regime for the market began in July 1997, stocks went on to rally for three more years before ultimately collapsing with the dotcom bubble.

If anything, today's "volatility" seems like the same old "uncertainty" canard in new clothing. It's a way of wriggling out of a call on whether a stock or an index is a buy or a sell at a given price, or on whether political and economic fundamentals themselves (as opposed to our perception of them) are really changing.

More volatility ahead? Sure--but think twice before investing in it.

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