Saturday, December 22, 2012

Volatility and Risk

Volatility is an inherent characteristic of all liquid financial markets.  Some of us perceive volatility equate to risk. But winning traders and winning investors understand that the presence of volatility means opportunity, not risk — so long as it is handled in the proper context.

Risk is the potential for permanent capital loss, which has no necessary correlation to volatility at all. For Example, which market environment was “riskier,” from a value investor’s perspective: March 2007, when volatility was at rock-bottom lows with market valuations sky high… or March 2009 (the nadir of the global financial crisis) when conditions were exactly reversed?

All truly robust (long-term profitable) poker, trading and investing strategies must endure “drawdowns” — periods of adverse volatility excursion, i.e. dips and troughs in the equity curve. In a strange way, the presence of equity curve volatility (and carefully managed drawdowns) can actually be a positive, to the degree that survival signals robustness. A methodology that undergoes routine “stress tests,” yet continues to grind out new equity highs, is far more desirable than a “perfect” methodology that has never been tested at all.

(Taken from Peter Brandt Blog)

[Contributed by Vibhor Rastogi]

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