Volatility Risk:
Volatility Is Not Risk

Regarding volatility risk, Chuck Carnevale of EDMP wrote an interesting piece of market commentary on Seeking Alpha entitled Why the Stock 'Market' is Like No Other Market. Carnevale's work is substantive and thorough, and almost always offers much to think about.

This particular article, for instance, elicited not one response from me, but two. But instead of hurriedly cobbling together my thoughts and posting them in the comment section of the Seeking Alpha piece, I've decided to take my time and draft something a little more formal and considered. I believe that the implications to long term investors warrants it.

The result is this page and one other: How to Invest in a Secular Bear Market.

Volatility Is Not Risk

For Carnevale, volatility risk is illusory, at least for long term investors, and he makes his case cogently:

"In the investing world, much is written about volatility. Many even consider volatility to be synonymous with risk. In our view, the risk is not the volatility; rather it's the reaction to volatility where true risk resides. If I am not planning to buy or sell today, then today's volatility does not, or at least should not, concern me. I know that in the long run operating performance is what matters most. I am better served focusing on how the businesses I own are performing."

For traders, volatility risk is very real, of course, because volatility is both risk and opportunity. That's just the nature of trading. I've written elsewhere that trading, especially option trading, is essentially leveraged bets on nothing other than the near term behavior of other traders.

For traders, it's imperative that they cut their losing bets short, not attempt to ride them out. For Carnevale and his long term investors, the opposite is true. Traders make their living by their own wits and efforts whereas long term investors make theirs by sharing in the real profits from the real operations of real businesses

But what about those of us who are somewhere in between--savvy long term investors who own shares of high quality companies that we intend to, in Warren Buffett style, "own forever," but who have also learned to use options from an investing perspective rather than from a trading perspective?

For those of us who use various option trading strategies to either acquire quality stocks for significant discounts or to continually lower the cost basis on our existing holdings (the twin purposes of what I call Leveraged Investing), do market fluctuations pose the same risk to us as they do to pure traders?

The answer is a resounding no.

Volatility Risk

Successful traders maximize their gains and limit their losses. Successful investors embrace high quality businesses at reasonable prices and shun everything else.

Successful Leveraged Investors place the same emphasis on quality but stack the deck in their favor on pricing because they've learned that option trading--conservative, sensible, and patient option trading--makes cost basis as malleable as wet clay.

I'm constantly harping about the crucial role of quality investments in long term investing success. But another factor that is of equal importance is the role of leverage. Or at least the amount that you use.

It basically comes down to this: The more leverage you employ, the less your performance is tied to the operating performance of the underlying business.

Leveraged Investing obviously depends upon the use of leverage (options are a leveraged instrument after all and allow you to control more shares than you could with cash alone). But the key distinction to make is that with Leveraged Investing, your option positions, your levels of leverage as it were, are limited.

Volatility Opportunity

The beauty of investing with options rather than trading with them is that your option trades don't have to do all the work. By enhancing your investments rather than replacing them, they only have to do part of the work. Therefore there's less need (or no need, for that matter) to over leverage.

Leveraged Investing is not a particularly difficult discipline. The hardest part isn't the nuts and bolts of the individual strategies. It's not even fully grasping the twin tenets of Leveraged Investing: quality investments and easy does it.

The hardest part is remaining disciplined and not over leveraging when you see how easy it is to make money with this approach.

But when the bottom drops out of the market, as it invariably does from time to time, you'll be happy you took the more conservative approach and spared yourself unnecessary volatility risk.

Save some cash and most of your margin for when you really need it - not to maximize performance when the market is rewarding long term investors but to navigate the croc-infested waters when the market is decidedly not rewarding long term investors.

Sometimes bad things happen to good stocks, and you'll want all the flexibility you can muster so those bad things don't, in turn, happen to you. Quality investments will come back; option investing restraint, like conservative option investing itself, can help to speed up the process.

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