This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
EXCLUSIVE OFFER: Jim Cramer's Protégé, Dave Peltier, only buys Stock Under $10 that he thinks could potentially double or triple in the next 6 to 12-months. See what he's trading today with a 14-day FREE pass.

Learning to Live With Volatility and Disorder

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.
  • Rule No. 2: "Favor businesses that benefit from their own mistakes, not those whose mistakes percolate into the system." Certain industries -- such as the restaurant business (when their meals are poor in quality, they have to improve the quality in order to survive) or the airline industry (whose safety measures improve after each disaster) -- are anti-fragile. Success should be an outgrowth of adversity. By contrast, each bank failure hurts the entire system.
  • Rule No. 3: "Small is beautiful, but it is also efficient." Size often increases fragility. The elephant breaks his leg at the slightest fall, but the mouse is unharmed by a steep fall. (This helps to explain, in part, why we have more mice than elephants!) We need an economic system that distributes risk along a wide range of sources.
  • Rule No. 4: "Trial and error beats academic knowledge." Potential errors should be small; potential gains should be large.
  • Rule No. 5: "Decision makers must have skin in the game." We ended up in the financial and economic soup in the last cycle because bankers had a "tails I win heads you lose" compensation system. Whether that compensation includes a large portion of stock or whatever it takes, corporate executives must have a significant and vested interest in the companies they manage. They must be accountable for lack of success and must suffer financially when there is failure to execute.

So, how do we incorporate Taleb's socioeconomic lessons into our investing playbook?

Many of my most successful hedge fund friends have made their fortunes in buying and holding -- namely, by discovering investment acorns that rise into mighty oaks. They contend that, regardless of the environment, there will always be those opportunities.

Many of these hedge-hoggers have prospered by bottoms-up stock picking and have often downplayed the macroeconomic backdrop.

But perhaps the landscape has changed and the investment fields are simply not as fertile as they were in the old days.

Are We Stuck in a Broad Trading Range Over the Intermediate Term?

I would conclude that, while my hedge-hogger friends might be correct -- though for many, it has paid mighty dividends -- the unique conditions that exist today make the harvesting of those great investments ever more difficult. Indeed, there are numerous fundamental, valuation, sentiment and technical factors that support the notion that both the upside reward and downside risk might be limited (ver the intermediate term.

Select the service that is right for you!

COMPARE ALL SERVICES
Action Alerts PLUS
Try it NOW

Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
  • Weekly roundups
TheStreet Quant Ratings
Try it NOW
Only $49.95/yr

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
  • Upgrade/downgrade alerts
Stocks Under $10
Try it NOW

David Peltier, uncovers low dollar stocks with extraordinary upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
  • Weekly roundups
Dividend Stock Advisor
Try it NOW

Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Alerts when market news affect the portfolio
  • Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
Real Money Pro
Try it NOW

All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.

Product Features:
  • Real Money + Doug Kass Plus 15 more Wall Street Pros
  • Intraday commentary & news
  • Ultra-actionable trading ideas
Options Profits
Try it NOW

Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • 100+ monthly options trading ideas
  • Actionable options commentary & news
  • Real-time trading community
  • Options TV
DOW 16,960.57 -123.23 -0.72%
S&P 500 1,978.34 -9.64 -0.48%
NASDAQ 4,449.5640 -22.5440 -0.50%

Our Tweets

Brokerage Partners

Top Rated Stocks Top Rated Funds Top Rated ETFs