Learning to Live With Volatility and Disorder

Tickers in this article: FIRE
This column originally appeared on Real Money Pro at 8:08 a.m. EST on Nov. 19.

NEW YORK ( Real Money ) --

One day, the sardines disappear from their traditional habitat off the Monterey, Calif., shores, the commodity traders bid the price of sardines up, and prices soar. Then, along comes a buyer who decides that he wants to treat himself to an expensive meal and actually opens up a can and starts eating. He immediately gets ill and tells the seller that the sardines were no good. The seller quickly responds, "You don't understand. These are not eating sardines; they are trading sardines!"

-- Seth Klarman , Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor

Five months ago, I was speaking to the legendary Ira Harris (one of the most influential Wall Streeters over the last 40 years; back in the day, he ran Salomon Brothers' Chicago office), who mentioned that he could not remember a time during his investment career when there was so much uncertainty as there is now.

Ira's fears of uncertainty ( mentioned earlier this year ) represent the reality of the times today. Human beings fear that which they do not know, be it economic, social, political, geopolitical or even environmental (especially of a climate kind).

The market's wild swings and Hurricane Sandy are the most recent reminders of the world's fragility -- it is a world far different than when my Grandma Koufax was investing years ago.

Over the weekend, Nassim Nicholas Taleb wrote a thoughtful editorial in The Wall Street Journal that underscores that investors must learn to live with disorder and volatility.

An important contributing factor to the market's volatility and disorder is the more frequent emergence of black swans .

In economic life and history more generally, just about everything of consequence comes from black swans; ordinary events have paltry effects in the long term....

Modernity has been obsessed with comfort and cosmetic stability, but by making ourselves too comfortable and eliminating all volatility from our lives, we do to our bodies and souls what Mr. Greenspan did to the U.S. economy: We make them fragile. We must instead learn to gain from disorder.

-- Nassim Nicholas Taleb, " Learning to Love Volatility ," The Wall Street Journal (Nov. 17)

Volatility and disorder are likely a constant state in a global economy that is experiencing a new normal that remains on tenterhooks, still experiencing the tail issues stemming from the last down cycle and, as a result, only experiencing a fragile trajectory of growth.

Below are Taleb's five rules for prospering in a world in disorder:

  • Rule No. 1: "Think of the economy as being more like a cat than a washing machine." Policy aimed at stability and the absence of pronounced cycles is misplaced. As Taleb writes, "The state should be there for emergency-room surgery, not nanny-style maintenance and overmedication of the patient -- and it should get better at the former." Cease bailouts and keep safety nets as long as they encourage entrepreneurs and do not increase dependency.