Volatility Isn't Necessarily Risky, But It's Not Risk-Free Either

I agree with Daniel Carroll that beta is a stupid way to measure risk. Only he was more eloquent:

I do not believe volatility is a good measure of risk. It measures phenomena that I do not consider to be risk - like the silliness of the market - and it fails to capture very real underlying risks.

This philosophy is shared almost universally by value investors--that market price and intrinsic value are two different things and that volatility of the former does not necessarily reflect change of the latter.

If volatility isn't risky, then why did I state in this post's title that it's not risk-free either? Because the ability to ignore volatility is a luxury that not all investors have.

If you buy stocks with borrowed money, volatility can wipe you out faster than you can say "margin call." Your broker is not interested in stories about the long term revelation of intrinsic value. He's interested in collateral.

Don't buy stocks on margin? Well maybe (just maybe) you have expenses. Suppose you need to sell a stock to pay for medical bills, but volatility is not cooperating. You can only liquidate at market bid, not at intrinsic value.

If you are a professional money manager, volatility can kill you. When the market's down, clients call. Nobody's happy to see their savings evaporate. The argument that in due time they'll make it all back and then some does little to mollify.

Have a down year and your performance record suffers. Your bonus suffers. Maybe your job is put at risk. Heck, if you are sharply down even for a month it gets harder to raise institutional capital. The allocators are obsessed with monthly volatility.

Your boss, your investors, your performance record, and the capital allocators care not for your fantastic investing process or what's to come in three years. They care about the red number on this month's account statement.

So should value investors start managing short-term volatility instead of long-term wealth creation? Of course not.

Then what's my point? Unless you are an individual investor with an unlevered portfolio and no near term need for the assets, volatility has real consequences. If you don't fit that description and your game plan is to ignore or exploit volatility rather than eschew it, make sure you are financially and emotionally prepared to handle the stress.