By way of Michael Covel’s blog came an excellent reminder from Nassim Taleb:
Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These artificially constrained systems become prone to “Black Swans” — that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers.
Such environments eventually experience massive blowups, catching everyone off-guard and undoing years of stability or, in some cases, ending up far worse than they were in their initial volatile state. Indeed, the longer it takes for the blowup to occur, the worse the resulting harm in both economic and political systems.
Seeking to restrict variability seems to be good policy (who does not prefer stability to chaos?), so it is with very good intentions that policymakers unwittingly increase the risk of major blowups. And it is the same mis-perception of the properties of natural systems that led to both the economic crisis of 2007-8 and the current turmoil in the Arab world. The policy implications are identical: to make systems robust, all risks must be visible and out in the open — fluctuat nec mergitur (it fluctuates but does not sink) goes the Latin saying.
In financial markets, there are all kinds of ways to constrain volatility, almost all of them unhealthy. In fact, investors are so concerned with volatility and will do so much to avoid it that they unintentionally court disaster. Bernie Madoff was able to hoodwink legions of investors because he purported to reduce volatility. A lightning strike in Yellowstone National Park turned into a firestorm because the system had been artificially constrained by decades of putting out forest fires immediately—when the National Park Service decided on a new policy of letting fires burn out naturally, they forgot about all of the excess fuel that had built up over the years of artificial constraints. In a noble, misguided attempt to preserve the scenic forest, much of it was destroyed in a single burn.
Investors are notorious for wanting the returns of good investment factors, while wishing to diminish the volatility. This is a really good way to be involved in a massive blowup somewhere down the road. Just because the risk is not immediately visible does not mean it has been eliminated. This is probably not a road you want to go down.
I became infamous at a certain Morgan Stanley investment conference a couple of years ago when I compared volatility to baby poop, admittedly not a typical investment topic. When you have a baby, you have to deal with baby poop. It’s just part of the process. As a parent, you are so pleased with the infant that you don’t see it as a big problem. No one tries to optimize for a baby that doesn’t poop. You just deal with things the way they are.
Similarly, investors are wasting their time trying to optimize return factors to reduce volatility. Volatility is just a feature of the return factor—in fact, consider that the existence of the volatility may be part of the reason that return factors remain exploitable for generations.
Relative strength has been a reliable return factor for a long time, but it is also accompanied by significant volatility. (The same thing is true of deep value, by the way.) To my way of thinking, the fact that the volatility is out in the open is important. Lots of investors are dissuaded from using it, which leaves the factor return intact. It also makes the return factor robust, since hidden risks are not building up silently. What you see is what you get.
Posted by Mike Moody 
