A thunderstorm parked over my Idaho town a few weeks ago leading to flash floods. It was an excellent metaphor for how the financial world works.
I saw the approaching storm as I drove toward home, and it didn't look terribly menacing. There were a few standard-looking cumulonimbus clouds overhead that pass by this time of year and sometime bring rain and sometime don't.
Only this time instead of moving on the clouds stayed on top of us, dropping two inches of rain in less than an hour‒almost 15% of our annual rainfall with one storm.
Flooding ensued. Basements were inundated with water. Canals overflowed. Streets became rivers.
The storm's severity was completely unexpected. The weather bureau didn't predict it. It was also very localized. A few miles south and north of my home it didn't rain at all.
Thunderstorms are an example of a non-linear system. A non-linear system is one that does not produce the same result every time even though the inputs and conditions are the same.
For example, if sand is dropped from above one grain at a time, it will create a cone-shaped pile that seems relatively stable. At some point, though, a grain of sand will hit the pile and trigger an avalanche.
You would think the quantity of sand in the pile would be roughly the same each time an avalanche starts, but that is not the case. An avalanche can be triggered with only a few hundred grains of sand or thousands. The timing of an avalanche is not a function of the size of the pile but the dynamic interaction among the grains of sand‒how they shift and slide relative to each other; their interdependence.
The more grains of sand, the more interactions and the more difficult it becomes to predict when an avalanche will occur.
Financial markets, like piles of sand and thunderstorms, are non-linear. They are a special class of non-linearity called a complex adaptive system. Unlike a sand pile that is comprised solely of sand, a complex adaptive system is comprised of a wide variety of interconnected inputs that adapt and learn over time.
There are millions of individual agents, both human and computer, that comprise financial markets, each striving to interpret ream upon ream of data about the economy, politics, business, technology and human nature.
Since market inputs are diverse and they adapt over time, the interactions are even more complex than those found within a sand pile, making it impossible to predict when the next market avalanche will occur. It could be this year or it could be in five.
How should you act in the face of such unpredictability?
First, don't listen to doomsayers who are convinced financial calamities are imminent. They don't know.
Second, since avalanches are infrequent, the most logical course of action is to assume the next grain of sand will NOT cause an avalanche. In other words, stop fretting about when the next financial calamity will hit and live a meaningful life.
Third, know that financial calamities will eventually come so be prepared. That means you should scale your exposure to risky assets, such as stocks, to your ability to recover when a market sell-off occurs. Younger investors have a greater ability to withstand market downturns because they have more time to recover from losses, their account balances are smaller and they are continuing to save.
Fourth, while it is impossible to predict when a market downturn will occur, it is possible to know when conditions are ripening for a financial calamity.
Although meteorologists can't predict if a severe thunderstorm will hit a particular town, they can determine if atmospheric conditions are such that the probability of a severe storm is high.
Examples of financial conditions when market downturns are more likely are when asset categories are expensive, investors are euphoric, debt balances high and the economy is slowing.
Financial calamities can be destructive but there are also positives. They clear out market excesses and provide for excellent investment opportunities for those that have the foresight to be prepared for market corrections, not knowing when they will come but that they eventually will.
This article was first published in my weekly column for the Standard Journal newspaper.
-J. David Stein | August 6, 2014
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