In case you were wondering . . . Part 1 – Volatility

In the last fifteen years, turmoil in the financial markets has caused great harm - jobs lost; savings destroyed; retirement delayed. This is the first in a series defining financial events and terms. I hope the information will illumine and improve your chances in the financial markets.

The series begins and ends with your Investment Portfolio. A portfolio is a collection of assets and the debt incurred to acquire them - insurance to cover the unexpected and retirement. A portfolio should have purpose and include diverse investments. Diversity takes advantage of the opposing natures of investment categories to hedge and balance risk.

This article addresses the nature of risk in securities. A Security is a negotiable instrument conveying financial value. Securities are equity – common and preferred stock; debt – bond, mortgage, loan; or derivative – option, forward, future, or swap.

Price volatility is the primary source of risk. The term refers to the frequency and amount by which the market value of an asset varies from its average over time. It is measured by the Standard Deviation. All securities experience some volatility. The extreme is the problem.

About 40 years ago, business schools began advocating the broad use of short term investment strategies. These strategies were not new but limited to certain investments. Instead of valuing performance over years, future money managers and traders were taught to seek profits from individual trades and measure performance by year, month or less. This strategy required active markets - frequent trades capturing momentary price changes and volume making it worthwhile. Derivatives were developed to create new sources of gain from a security. Advances in technology facilitated and compounded by allowing speed, volume and the globe. This change in strategy elevated the risk of investing.

Why consider Volatility a source of risk? At high rates, the credibility of the security and/or market can be questioned. High Volatility can signal or enable manipulation. Since the 90’s, we’ve seen Volatility in pricing (Irrational Exuberance) and marketplace distrust (The burst Tech Bubble). The S&P downgrade triggered volatility fueled by manipulation and distrust.

Volatility challenges the liquidity of an investment. Liquidity refers to the ease with which a security can be exchanged for cash. So, most shares of stock are more liquid than an acre of land. But, if market volatility pushes a valuable stock into loss position, however readily it can be sold, to the seller it has lost liquidity.

In a short term strategy, security traders need Volatility. Money is made on “inefficiencies”. In an efficient market, prices mirror real value. Volatility can indicate an error – a possible inefficiency. Whether an error in price, market, or manipulation, the pros have the tools to make a profit. After the S&P downgrade, stock markets were deluged with sell orders and prices plummeted. Someone saw great opportunity – the securities were purchased.

Most individuals invest for long term appreciation and income. Due Diligence is the key to investing in a volatile market. Will the investment serve purpose and the portfolio? Do the quality and price meet risk/reward standards? If you can’t hold until maturity, is it liquid?

How does the individual use Volatility? In August I placed an order to buy four dividend bearing common stocks. I set prices below market in anticipation of the S&P downgrade. The tactic worked. But, the strategy only works if the companies succeed and I hold long enough. The dividends will finance the purchase of more shares with the next big price trough. Volatility will enhance the return by keeping basis low.