Risk Was Never Low, It Was Only Hidden
The vast majority of market participants are about as ready for a semi-random “volatility event” as the dinosaurs were for the meteor strike that doomed them to oblivion.
Judging by euphoric gambler–oops I mean “investor”–sentiment and measures of volatility, risk of a market drop has been near-zero for the past 18 months. But risk was never actually low, it was only hidden. When it emerges, it’s a surprise only to those who mistakenly thought risk had vanished.
As Benoit Mandelbrot explained in his book The (Mis)behavior of Markets, crashes are an intrinsic feature of systems like stock markets. These risks are not generated by specific human actions or sentiment but by the system itself.
Just as humans make subconscious decisions and then conjure up quasi-rational justifications for their choice after the fact, market participants always conjure up some event or decision as the cause of the crash. Favorites include central bank policy error, black swan events (“bolts from the blue”), earnings surprises, technical levels were breached, and so on.
Mandelbrot’s insights reveal why markets crash without any policy error or other fabricated- after-the-fact justification: as those who witnessed the collapse of Japan’s massive credit-asset bubble in 1989-1990 observed, markets just stopped going up and started falling.
Risk is a reflection of many dynamics, but the key dynamic few participants seem to understand is the inherent instability of complex systems: surface tranquility is not an accurate reflection of the actual state of stability or risk, no mater how long the period of tranquility stretches.
The human mind rebels at the dominance of quasi-random crashes, as our hubris and need to be in charge generates an illusion of control:…
…click on the above link to read the rest of the article…
