“History does not repeat itself, but it often rhymes” might be the best quote attributed to Mark Twain, that he never uttered. It’s also the most overused quote about markets.
And yet, it’s true. History rhymes because it’s a continuous sequence of events, each event influencing the next, with uncertainty around every corner.
Uncertainty is the secret sauce in the system, according to Peter Bernstein. Investors who fail to understand it — or fail to remember the cycle it creates — are doomed to repeat the mistakes of the past.
At every step of the way, the capitalist system plunges the businessman into deep uncertainties as to the outcome of his decisions.
This feature is both the genius and the devil of our system… Both the business cycle as we usually think of it and the longer-term variations in business activity reflect the alternating domination of first, the genius, then the devil. When the rewards to risk and enterprise appear large, businessmen walk the earth with pride, boast about the superiority of our system, take excessive risks, and consequently tend to forget the inevitable uncertainty of outcomes in an unplanned system. When reality dawns and depression sets in, they hang their heads in shame and, obsessed with uncertainty, tend to forget the rich rewards that the system will pay to those with a spirit of enterprise and an appetite for risk.
Familiar as this analysis may be, two aspects of it are crucial to understanding the nature of the…crisis. They contain the ultimate truth of what our system is all about.
First, the system fluctuates between these two types of environments because each is the cause of the other. The easy attitude toward risk in the euphoric stage is what brings the good times to an end. Risk-aversion and caution eliminate the excesses and lay the groundwork for richer rewards ahead.
Second, human beings seem constitutionally incapable of remembering that this process of alternation is inevitable, even if is timing is difficult to predict. Indeed, one reason why the timing is so tricky is that people take so long to recognize change and to recall that it is inevitable. Yet what happens tomorrow will be different from what happens today precisely because we are making efforts today to adjust to whatever it was that happened yesterday. The child is the father of the man, as Wordsworth reminded us.
But once we understand that this process is precisely what makes our system so dynamic, a fundamental fact of life in general becomes especially appropriate to this line of analysis. It is this: solutions create problems! By this I mean that we may be successful in devising solutions to today’s problems but that those solutions are destined to become in turn the problems we will have to solve tomorrow.
The question, of course, is what are those problems? It won’t be something everyone expects but the thing we least expect. Because expected problems — the obvious and apparent ones — should be carefully watched and dealt with if needed.
The problems that go unnoticed, the surprises, is what Bernstein is talking about. It triggers the realization that uncertainty (still) exists and the behavioral switch from risk-taking to risk-avoiding that keeps the cycle rolling.
These unexpected problems are guaranteed to inject chaos into markets. How do we prepare for something like that?
First, realize you can never build a portfolio that protects against every risk. Portfolio allocation is really about managing tradeoffs.
Second, know that volatility is built into the system and tied at the hip to uncertainty. It rises and falls as market participants are reminded, and later forget, that uncertainty is ever present.
Third, accept that some losses are inevitable. Nobody bats 1,000 in this game because uncertainty won’t allow it. Build the best portfolio you can, knowing it won’t be perfect, that some years will be better than others, and that over time it will win out.
This post was originally published on June 19, 2020.
Source:
Is the System Still Working?
Related Reading: