The media likes to characterize volatility as a bad thing. For them, the narrative is the stock market is only volatile when it’s going down. I’m sure you’ve heard the term all week on CNBC or Fox Business. Using the term "volatility" is meant to scare people and, perhaps cynically, it’s used to generate a lot of eyeballs glued to their TV screens. But if you’re a savvy investor, you know that volatility is a good thing; especially when it jumps higher. In truth, it is volatility that makes the market worth pursuing as an investment strategy.

Actually, volatility is a fundamental and highly desired underlying characteristic of the stock market. Think about it… if there was no volatility, there would be no way to generate a return.

The word “volatility” can be interchanged with the word “risk”. You have to accept volatility and in exchange, you have to be willing to accept a certain level of risk in the stock market to be able to achieve positive returns.

But how much risk is the right amount? Let’s take a look at one of the stocks we owned recently. (NOTE: I am not recommending this stock one way or the other.):

Kroger Co. (KR) is a well-known grocery chain. It recently began to show up on our list of potential buys in the second week of July.

Our internal algorithms identified it as a stock we wanted to own and put it into our watch list to see if volatility would push its price low enough to make it an attractive buy. Our quantitative analysis algorithms told us that the best entry price would be below $40 per share. And thanks to volatility, the price of KR dropped low enough for us to buy it for our clients on July 26th when we picked it up for $39.80 per share.

The month of August was good for the stock. KR continued to move higher as our algorithms expected. Every week, as the share price moved higher, we would raise our exit price. Soon, the exit price moved above our basis and the stock's share price kept moving higher. With our exit price well above our basis, we virtually locked in a profit.

But the last several days of August saw the stock rolling over and its share price weakening. After a couple of days of the stock moving back up a bit, it began to fall again until it hit our pre-determined exit price in early September locking in a profit of nearly 10% in just a little over a month.

And what happened next?

KR kept moving lower, dropping in price almost daily.

Our rules and discipline got us into KR at a good point and got us out for a solid profit. We did not fall in love with KR, even though Warren Buffett did. He bought it in July right after we did and I can only assume he still owns it where it is now just barely breaking even.

Did we know that KR was going to rise after we bought it? Of course not. But the algorithms we’ve developed locate stocks that have the propensity (not the guarantee) to keep rising . The inherent volatility in KR worked in our client's favor.

Did we know that KR was going to continue falling after we sold it? Of course not. But the same algorithms we developed to find stocks also help us determine a good time to exit.

Investing is a continuous balancing act… IMPORTANT!

On one hand, we want to get into stocks that have the propensity to move higher and make money for our client accounts. On the other hand, we don’t want our clients to take on a large amount of risk. We are always looking for ways to mitigate undue risk and uses predetermined exit prices to help in that process. Picking the right exit price is critical in this process. I'll post another blog in the near future that describes how we set exit prices. Buy and hold strategies do not use predetermined exit prices and that opens the door for those strategies to incur unlimited downside risk. Our clients are savvy enough to understand that kind of risk is simply too high.

That’s why intelligent risk management is the key to being a successful investor!

Savvy investors know that there will always be ups and downs in the markets. Some trades will be small winners and some will be small losers. Some trades will be large winners. And, unfortunately, many investors will have trades that become large losers because they have no preset exit strategy. Savvy investors know how to set exit prices and not to second-guess the predetermined exit price so that there will be no large losers.

The balancing act of risk versus reward can be summed up in a single sentence:

“The key to making a killing in the stock market is to not get killed!”

Savvy investors never panic; assuming they have rules that they use to invest with.

I like to say, “You make the rules, but the rules make the trades.”

One rule is to not fall in love with any stock… it’s just a piece of paper. As long as it is making you money, it is useful, but never worth falling in love with. Loving a stock will cloud your emotions and cause you to ignore your selling rules.

Indeed, there are many rules that anyone who trades in the stock market should follow. I have written about many of these rules in a couple of books I’ve written.

Here is the big take-away from this blog…

A savvy investor will either manage their own money or hire an investment manager that has a solid set of rules and the discipline to follow those rules. We have a rule for every market condition that has occurred in the past 100 years. And, we are disciplined… totally. Does this mean there is never a down day or down week or even a down year? No, it does not, but it does mean that risk is ALWAYS properly balanced in the risk/reward equation. It means that, over time, a rules-based active management strategy will take on far less risk than a buy-and-hold strategy and will outperform in the long-run by a considerable amount.