Volatility Is Not Risk; Permanent Loss of Purchasing Power Is

The idea that volatility equates to risk is a self-imposed dungeon constructed by over-leveraged traders and those who lack understanding of the intrinsic value of the assets they own.

For traders who make heavy use of margin, volatility can trigger margin calls and force them out of positions prematurely at disadvantageous prices. For option traders, unexpected volatility can render once-promising option contracts worthless. Even though traders can attempt to widen their stops, wilder-than-expected volatility can smoke them out of a position when a seemingly “untouchable” stop loss is unexpectedly triggered.

If you are navigating the markets in a manner so that risk must be defined as an asset fluctuating in price, you are making the game more complicated than it has to be. If you operate properly in the market, the idea that volatility equals risk becomes absurd. A stock fluctuating wildly is not risk; the permanent loss of purchasing power is.

Volatility doesn’t have to equal risk if you choose to play the game right.

How Investors Can Turn Volatility Into An Ally

Let’s say you have thoroughly researched a $25 stock and its underlying company. Based on your estimates, you believe the stock will be worth $100 per share in 3 years. You are confident that the company has the capital to execute its plans and will not need to sell equity to raise capital within that time frame, so you buy shares of the company with approximately 10% of your cash balance with the intention of owning shares for 3 years under the condition that the company’s results loosely follow your optimistic expectations.

If you have positioned yourself carefully and prudently in this manner, then volatility becomes your ally. If the stock declines from your purchase price of $25 to $18 in the first year, it should not be seen as a disaster if the underlying company is still performing to your expectations and your $100 appraisal is still valid. Instead, the decline in stock price should be seen as an opportunity. When your favorite food at the grocery store is selling for 30% less, you naturally feel compelled to take advantage of the lower prices and stock up. The same logic must be applied to your well-researched, high-upside potential stock. In this situation, you might decide to increase your stake to 15% from your original 10%, or even 20% depending on your risk tolerance. Since an $18 investment that rises to $100 is a better deal than an $25 investment that rises to $100, the logical thing to do is buy more at $18, not panic.

The notion that your stock is suddenly more risky or less desirable simply because its price has temporarily declined is irrational. If your time horizon is 3 years, having a paper loss in the first year is irrelevant for the simple reason that you never planned on liquidating the position in the first year to begin with. And since you used cash for your stock purchase, holding on to the position is free: you are not paying margin interest, and there is zero risk of a margin call pulling the rug from under your investment and forcing you to realize the paper loss.

The Concept of Mr. Market

For investors, Benjamin Graham’s concept of Mr. Market (from chapter 8 of his 1949 classic, The Intelligent Investor) is the most practical framework for navigating volatility. Graham taught his students to view the market as a “bipolar drunk” who knocks on your door every morning with an offer to buy and sell stock. Sometimes he offers to sell you shares for way less than they are actually worth, and other times, he offers to buy your shares for way more than they are actually worth.

“You may be happy to sell out to [Mr. Market] when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.”

Benjamin Graham

In order to take advantage of Mr. Market, you need to be knowledgeable about the assets you are buying and selling. If you understand an asset’s worth, you have an edge over less sophisticated market participants because you know objectively whether a stock is cheap or expensive.

In any market, knowledge provides an edge.

For example, how can a real estate buyer know if a piece of property is cheap or expensive if they fail to appraise the property? Worse, what if the real estate buyer chooses to rely on the opinions of others to make a decision? The risk of deferring to others is that the adviser may be incompetent, not seeing things clearly, or even intentionally trying to sabotage your results.

Another example: if two people went to bid on a car that needed some repairs and one was a mechanic and the other had no experience in anything vehicle-related apart from driving one, who do you think has the better chance of getting a better deal? Who is less likely to overpay for the car? The mechanic, of course.

As Warren Buffett said, “The market is there to serve you, not to instruct you.” In other words, never defer to the market for advice on what to do with your stock; that’s not what Mr. Market is there for. If a car dealer pitches you a 2000 Honda Accord for $250,000, don’t immediately assume there’s something special about it, even if other people are buying it. They might be just as clueless as you.

An Illustration of How Price Traders Become Slaves To Volatility

Since I illustrated above what a volatility-friendly investment process might look like, here is what the opposite would look like:

Let’s say you are an active trader who is also buying the same stock as the investor in the above example. But you never did a deep dive on the company or attempted to price the stock’s intrinsic value so you don’t know much about the company except surface-level information. Instead you looked at a chart, concluded that you observed upside momentum, and bought the stock at $25 with the hopes that it would rise to $30 by the end of the month. To protect yourself, you place a stop at 2X ATR which happens to be $19 for this particular stock. But to your surprise, two weeks later the stock has declined all the way to your $19 stop level.

Unlike the investor above who actually had an idea of what the company is worth, you do not. Therefore, it would be unjustifiable for you to average down and buy more stock. After all, the reason you entered the stock is because “you thought it would continue going up.” If you were wrong then, what makes you think you would be right now? Before, you were a neutral party with no position. But now you have money on the line and you’re bleeding. Any decision you make now would clearly be biased. Therefore, the right thing to do would be to follow your original plan, exit the trade at a loss, and permanently lose purchasing power.

In this case, volatility translated into a permanent loss of purchasing power through no fault of anyone else but the trader who willingly handicapped and self-imposed arbitrary limitations on himself.

Revenge Trading and Getting Whipsawed

The greatest danger of trading based on price and momentum is the tendency for a scorned trader to engage in “revenge trading.” If the trader decides to follow his plan and cut his losses at $19, he may be highly unhappy with the–let’s say–$15,000 loss he just took. So now he has a vendetta against this particular stock and wants to make his money back. He shorts the stock in hopes of riding the stock down to $14 because now he is sure that the market is headed down and not up. The stock dips down $1 and he feels validated. But then the stock begins to recover back to $25 and once again he is forced to exit the position at a loss.

While the trader was busy getting whip-sawed, demoralized, and taking permanent losses, the investor had shrewdly averaged down at $18, never allowing himself to get spooked into taking a permanent loss on an investment idea he had a strong conviction about. As his thesis played out, the stock jumped to $40 and then $60, but since he knew that the stock was worth $100, he did not sell at those prices either. So while the stock may have fluctuated within a large range over the next 3 years, the intelligent investor took advantage of Mr. Market to add to his position strategically and eventually sell at an outsized profit.

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