“Volatility matters when you feel it. All the charts, ratios and advanced math in the world mean nothing when you break down, vomit or cry due to the volatility in your portfolio. I call this the vomitility threshold. Understanding your threshold is important, for it is at this point that you lose all confidence and throw in the towel.
“Traders, portfolio managers and mathematicians seem well equipped to describe risk with a battery of formulas and ratios they use to measure volatility. However, even if you can easily handle the math, it can be a challenge to truly conceptualize it. The simple fact is that for the investor, the act of truly working through the thoughts and feelings that accompany losing money is hard. It is about as enjoyable as working through the thoughts and feelings associated with your death when preparing a will.
“There is no mathematical formula for vomitility because it is different for each person… For the [trader] who wants anything other than an interest-paying deposit at the bank, I think I can sum it up as follows: Surrender to the reality that volatility exists or volatility will introduce you to the reality that surrender exists.”
- Jason Russell, via Trend Following
Volatility tolerance varies widely. At one extreme, some traders look forward to 40% drawdowns as an opportunity to add capital. At the other extreme, a 4% drawdown over a six-month period could be seen as a gross failure of risk control. (Most of us fall somewhere between the two.)
What is your personal volatility threshold? How much portfolio heat are you willing to endure on a normal basis? As an absolute worst-case scenario?
Are your standard risk management protocols aligned with your natural volatility tolerance? Is your tolerance level appropriate to your strategy?
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