When something you expect to happen, doesn’t happen, you get surprises. In markets, the result is an adjustment in prices. Some people might call it volatility.

Of course, volatility carries a negative connotation (confusing it with risk hasn’t helped its image either). I’ve heard nobody is comfortable around asset prices that jump around a lot. It’s apparently so bad, that people purposely build strategies to minimize it in their portfolio. Their goal: avoid surprises.

A smart contrarian might see it differently: volatility — surprises — are a feature of markets. Expectations are often wrong, unexpected things happen, prices adjust sometimes dramatically, which creates opportunities for those less fearful of volatility. In other words, embracing surprise leads to opportunity.

Suppressing volatility is no different than attempting to remove surprise from markets. It’s not only impossible but it — probably, eventually — leads to more of the thing you’re trying to avoid. How does it go — “Stability leads to instability.” Continue Reading…

I’ve been reading a lot of Peter Bernstein lately. Bernstein wrote the book on risk, Against the Gods, along with several others, but my focus has been on his much shorter pieces. One that stuck out was a 2002 speech he gave to the Society of Actuaries.

In the speech, Bernstein makes it very clear that not only do we rely too much on averages, but we ignore the hidden lesson in the data being averaged — variety. Averages lead people to focus on “the whole rather than the doughnut,” as Bernstein puts it. So decisions revolve entirely around the averages.

One way to look at this is that the averages provide certainty where none exist. Basing decisions on averages work for most things, but investing comes with a nasty snag called uncertainty. Averages stop being perfect predictors once an unknown is involved. No matter how far back we go, the future makes asset return data incomplete.

Instead, we should view any output purely through the lens of only for the most part. The averages offer a rough guide of what’s possible but, just in case, we better understand the consequences of being wrong. Because being wrong can be devastating. And history — all that variety overlooked by averages — shows just how often results failed to live up to the averages and investors felt the consequences of being wrong. Continue Reading…