Extraordinary Claims Require Extraordinary Evidence


“Sh#t happens.” -Unknown

Financial markets have no resemblance to a closed scientific lab.

Physics and chemistry are based on successfully predicting future behavior; relying on these concepts when designing a portfolio is a recipe for disaster.

To be a good investor, you need to be an historical scientist rather than a chemist or physicist.

This means you have to account for the millions of uncontrolled variables that can dramatically change an outcome, for better or worse. This entails studying patterns over very long periods of time so the occasional craziness can be ruled out — instead of incorporated into your toolkit.

Think of the 1987 crash, when the Dow Jones fell 20% in one day. People are still not sure what exactly caused it. Most likely it was the right combination of uncontrollable and unpredictable variables which led to the financial equivalent of a perfect storm.

It would have been a dreadful error to base future investment decisions expecting this type of event  to frequently reappear.

Human behavior is unpredictable; sometimes small random decisions can change the course of history.

Here is an example of the extreme power of randomness:

In 1930, there was a minor traffic accident in Germany. Adolph Hitler was riding in what they call the “death seat” (the right-side, front passenger seat). The truck that was barreling toward him braked just in time to avoid demolishing Hitler’s car and crushing him to death.

If the truck driver braked a millisecond later, he just might have changed the entire course of world history!

Markets, like human societies, are extremely complex and are strongly influenced by millions of independent variables that feed on each other.

A small change somewhere in this ecosystem can have dramatic effects for everyone involved on all levels.

There are numerous examples in the financial markets that fit this concept.

So called “Fat Finger” trades are those trade input mistakes which could lead to a chain reaction of computer-generated selling (e.g., the Flash Crash of 2012).

President Eisenhower suffered a heart attack in 1955 and the market fell 6.8%!

More interestingly (and wholly counter-intuitive) is that, according to Forbes, market crashes are not generally caused by major and immediate bad news:

“Academics from Harvard and MIT, including Larry Summers, looked back through history, cataloging major events from 1941 and 1987 and examined what resulted for the S&P 500 stock index. These major events spanned from Presidential shootings to the starting of wars. Across all these 49 ‘event’ days, the market’s standard deviation, as a way to measure volatility, was 2.08% relative to 0.82% on a typical trading day.”

This fits the pattern of “no pattern” to explaining short-term market events.

The particles of physics and isotopes, along with chemists’ molecules, are identical to each other.

In other words there are no “crazy uncle” isotopes acting irrationally and causing havoc at the family reunion.

The markets are filled with crazy uncles.  Universal laws are not part of the equation.  This makes markets a very dangerous place for those who insist on certainty and order.

For the rest of us, understanding this concept is a liberating experience.

The correct long-cycle approach means less is more. Act like an historical scientist, and let the moments of insanity smooth themselves out over time.

In the meantime,  if you are thinking about creating your own portfolio science experiment, keep in mind the words of Voltaire: “Doubt is not a pleasant condition but certainty is absurd.” 

Source: Guns, Germs, and Steel by Jared Diamond





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