Slowly, then.........

I assume everyone has heard:

Question - “How did you go broke?”

Answer - “Slowly, then all at once”.

Aside from being funny, this is actually true in many cases.

For example, the global population is now aging rapidly and it has snuck up on policy makers even though we have known that global demographics were changing and soon may be on a path of no return. Slowly, then all at once. 

Covid started with a few cases in a regional Chinese food market and then spread rapidly as people travelled countries spreading it into local populations. Slowly, then all at once. 

A sand pile is often used as a metaphor for markets. They grow and climb ever higher until they reach a point where it collapses into a big mess of sand grains. Suddenly, then all at once. 

This way of thinking can be applied to markets since markets operate on the same principles. Called complexity theory and known as the network effect, it studies the movement and interaction between individual variables (often called agents) in order to try and predict the future. 

We know from studies show that it is virtually impossible to predict with any high degree of probability how markets will move and what the catalyst will be, but we do know that it will eventuate. 

Nassim Taleb calls these types of events, Black Swans, and although rare, a negative Black Swan event can leave a great deal of damage as we have seen with examples like the Great Depression and the more recent GFC. 

As investors we should accept that we can’t pick the top, but we can protect ourselves, and in some cases profit from these Black Swans. 

One way is to reduce your overall exposure to richly valued markets. Another is to “go short” seeking to profit from a sudden decline in the market. 

Alternatively, we can think about the market moving over time and develop a long/short portfolio. This is where we may remain exposed to the market, but  at the same time take a put option for a small price which bets that the market will decline. 

This is how we can benefit from negative correlation - where if “A” moves up, “B” moved down and vice versa. Many hedge funds take this approach. It is actually quite simple and an effective way to manage risk when the market is overvalued. 

But it is also surprisingly a way to generate higher returns in any markets thanks to the ability to use volatility to our advantage. 

At this stage in the market cycle, I am reminded of Buffett’s quip that holding cash is painful until that point where suddenly everybody wants it.