An old saying popped up in my head after seeing this week’s volatility.

“If you can’t swim – then don’t cross a river if it’s on average only 4 feet deep. . .”

Meaning – the river could only be one or two feet deep for most of it. But when you get to the middle – and it’s suddenly 16 feet deep and you can’t swim – you’re toast.

Thus – the main point here is: putting too much faith in the law of averages can be fatal.

But – unfortunately – that’s exactly what the mainstream does all the time.

I believe many economic models and financial ‘experts’ put too much faith in average outcomes – aka ‘normal distributions’ (the bell curve) . . .

They believe that the market will move slowly – and usually up – 99% of the time. Why? Because historically that’s what has happened.

And while I do agree this usually happens – that doesn’t mean you should discount that 1% of the time when things go crazy.

For instance – financial markets over the last 100 years weren’t some smooth trend upwards. That ‘1% of the time’ still wiped out trillions in wealth. Bankrupted many. Ruined governments. And demolished portfolios.

But – thanks to the wisdom of successful investors and philosophers like Nassim Taleb, Mark Spitznagel, and Benoit Mandelbrot – we can avoid blowing up.

And instead – we can actually use that 1% of the time to our benefit. . .

This is how I look at it – markets are usually efficient about 90-95% of the time. But there’s a couple things to understand here.

First – the big returns are made finding that 10% of the time when the market’s not efficient and completely mis-pricing assets.

It’s rare – but the market does sometimes value things completely wrong. And it’s important to find those times and exploit them (more on this later).

Second – the market really doesn’t have good long-term memory.

Meaning – if things are going well lately  – then the crowd starts believing it will be that way forever (and vice versa).

As I’ve written before – thanks to Hyman Minsky’s Financial Instability Hypothesis (FIH) – periods of peace and calm are the seeds for future turbulence and chaos. . .

Thus – when investors get comfortable during the peaceful times – they take on more risk.

But eventually – this added risk by the crowd piles up – and someday will become a ‘tipping point’.

It could be from an external problem like September 9/11 – or from the Federal Reserve raising interest rates.

Or maybe it’s internal – and the market’s perception of the future and risk simply changes.

This is the ‘tipping point’.

The crowd rushes to liquidate and salvage what they can – sending markets plunging.

Now – suddenly – investor are filled with fear and are ‘risk averse’ (won’t invest in anything).

The rubber-band snap of markets changing from risk tolerant to risk averse is called a ‘Minsky Moment’. . .

So, just remember this about FIH – a long period of consistent low volatility is the breeding ground for future high volatility; and vice versa. 

(I know I’ve written about Minsky often throughout the year – but I just believe it’s very important to understand. You can read my most recent Minsky piece here if you haven’t yet.)

A great example of when the market gets slaughtered by the ‘1% of the time’ event is what Nassim Taleb – one of my favorite thinkers and traders – calls The Turkey Dilemma. 

Just imagine a nice plump turkey on a farm. . .

The turkey’s taken care of and is given food daily. It lives in a nice open-range pen and freely trots around happily.

Then – as time goes on – the turkey becomes accustom to how things are (its daily routine) and feels safe and secure. Confident that tomorrow will be be much of the same.

And investors and economic ‘experts’ would use fancy math and collect past data to make forecasts over the next five years – feeling confident things would continue for the turkey.

That is – until it’s Thanksgiving Day and the farmer takes the turkey out back and chops its head off. . .

The irony here is that with each passing day – the turkey felt its risks declining as it grew use to the daily routine.

But – in reality – its risks are actually increasing as each day passed.

Thus – looking at the above graph – we can see that the turkey was at (or thought) its peak well-being and felt most confident just as the risks were at their highest.

Therefore – the takeaway here is – don’t be the turkey. . .

So – to summarize:

First – be cautious of ‘normal distribution’ models and charts that economists show and use to make forecasts. While data is handy for decision making – don’t put all your faith in it. 

Second – markets are relatively near-sighted and only remember the immediate past.

Meaning if things have been good lately – investors will expect that trend to continue. And if things are bad lately, they’ll expect the future to be lousy.

Don’t be fooled by this. Like Minsky taught – the calmer things are, the bigger spike of turbulence there’ll be. . .

Third – markets are rational most of the time – like 90% – but there’s that 10% of the time markets get irrational and mis-price assets significantly (like during bubbles or brutal bear markets for example). But finding that 10% period and betting against it can be very lucrative. . .

Fourth – just because markets are going up and they have been for a while doesn’t mean they will continue indefinitely. Like the Turkey that was becoming use to his daily life – the risks were piling up all around it. . .
 
You need to be an independent thinker, knowledgeable, realistic, and have a contrarian mindset.

Oh – and don’t forget – a lot of luck.

Stay tuned.