Profiting from Short-Term Volatility is a Tough Road

AS THE OLD SAYING goes, when elephants are dancing, mice get trampled.

And when it comes to the markets, we are all mice, including Bear Stearns, Sowood Capital and Goldman Sachs who are among those who've seen their investments either pounded or bankrupted altogether in recent weeks. The wide volatility has prompted stock, bond, currency and commodity markets to experience massive swings — and there haven't been plenty of places to hide, including cash. Countrywide Financial's (CFC) banking unit has had to quell a run on the bank amid bankruptcy rumors and Sentinel Management Group, a cash management firm for institutional clients, was forced into Chapter 11 bankruptcy protection. That's a cash-management firm folks, not exactly a growth stock shop.

It is often remarked that volatility creates opportunity. But generally speaking, I don't believe it is these types of environments in which fortunes are most likely to be earned. Meaningful profits never seem to come from one great day, but from exploiting the bulk of a long-followed trend that unfolds over months, not minutes.

So if you are buying stocks here and taking new positions I think you need to be buying them with the thought of revisiting Dow 14,000, not 13,200. As I always point out, one's goal should be to play for a big move. If you're considering much-battered Citigroup (C), for example, now around $48.50, I think you need to be playing for a move back to at least $60 — not $49.50. For my money, the financials remain a low-probability idea. What many might call "cheap" I'd call just plain unattractive.

But day after day of 100-plus point moves can bring out the gambler in even the most disciplined of traders. I'm getting more questions about jumping into leveraged bull or bear ETFs, such as those from ProFunds or Rydex, which offer twice or more the exposure to major indexes.

Even bearish investors can feel the addict's instinct to want to jump in and play for a bounce. Or after the market falls for three days, it's natural to want to be long on the third, imagining that "it's due for an up day."

Take it from someone who's tried: That sort of trading will get you killed. Last week is a prime example — before Friday's Fed-inspired rally, the market had dropped for seven straight days. Just when you think XYZ can't go any lower...too often it does.

Instead of buying securities that can't seem to go any lower, I prefer to look for opportunities in areas where others think prices can't go any higher. As we always point out, bull markets are built on doubt, not hope. So that "safe" financial stock that's down 35% from its high might not be the bargain it seems. And securities like CurrencyShares Japanese Yen Trust (FXY), up 4% since our mention in a recent column might not yet be played out.

In terms of making shifts, I'd also advocate by starting the evaluation with what's in your current portfolio. If you are well-diversified, not only among stocks but among different asset classes such as cash, bonds or foreign exchange, the effects of the volatility have been mitigated.

As was pointed out in a recent Wall Street Journal column FX has served as a "refuge from the subprime fiasco" — largely due to the market's deep liquidity — which we wrote about in early August. The fact that this relative outperformance was buried inside the paper rather than on the front page, leads me to believe that trend still has room to run.

Of course, investing is first and foremost a mental challenge. So regardless if you like British Petroleum (BP) or the British pound, investors should heed the wisdom of J.P. Morgan — not the company, but the man himself — who was once asked by a panicked investor, "What should I do with my stocks? I'm so nervous I can't sleep at night."

Morgan's advice? "Sell down to the sleeping point." Good advice for the housewife, the hedge fund manager, and every investor in between.