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December 11, 2011

The Myth: Volatility is Risk

That volatility equates to risk is a myth perpetuated by Modern Portfolio Theory (MPT). Based on this misconceived idea you have to buy losers to even out your winners. They say it backwards -- buy winners to even out your losers -- but it's really the same thing. Your losers will still be losers. Buying AAPL didn't help you with the Lehman bankruptcy, it just hid the mistake from your fund holders. And that is the point! MPT is great for fund managers because it reduces wave making and that helps to keep fund holders from selling at the worst possible moment, in the trough.

But it gets even better! If you are trading options, volatility is your friend. Option prices rise and fall with volatility. You sell options when volatility is high because options are expensive. You buy them when volatility is low because options are cheap.

One additional point. Volatility is risky when you are leveraged. Suppose you bought a home at the height of the housing bubble with 10% down. Today the house would be underwater and you still have to pay the mortgage. If you are also unemployed, you'll likely lose the house. But if you own the house free and clear, even if unemployed, no one is going to come to collect a mortgage and threaten you with foreclosure. The difference is not the housing price volatility but YOUR leverage.

When the financial bubble burst, falling security prices combined with mark-to-market accounting triggered margin calls, breaches of covenant and insufficiency of reserves which led to bankruptcy. The failing organizations have no control over volatility but they sure have control over the leverage then acquire. For them to blame volatility for their failure is like saying "The Devil made me do it." It's a cop out! It's like a high wire artist blaming gravity for his fall to death. The risk is not in Gravity but in the artist's chosen activity.

Denny Schlesinger

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