Streetwise for Friday, February 15, 2019

Have you ever noticed that a relatively insignificant news event, often unrelated to Wall Street, can trigger significant gains or losses in the equity markets? These oscillations portray what is popularly referred to as the butterfly effect. Specifically, a butterfly flapping its wings in one part of the world could potentially cause a disruption in the weather a thousand miles away. 

The name butterfly effect, coined by Edward Lorenz back in 1961, is derived from the metaphorical example of the constructs of a hurricane being influenced by minor unrelated perturbations, such as the flapping of the wings of a distant butterfly several weeks earlier. 

In seems that Lorenz was using a numerical computer model to rerun a weather prediction, when as a shortcut he entered 0.506 instead of entering the full number 0.506127. The result was a completely different weather scenario. The key point is that even a seemingly inconsequential change in an initial condition will create a significantly different outcome.

Consider the randomness of throwing dice. On each throw the outcome is dependent on small differences in the initial conditions, such as the precise direction, thrust, and orientation of the throw. The result is significantly different dice paths and subsequently the numerical outcome of the toss. Therefore, it is virtually impossible to throw dice the same way twice, much to the relief of Las Vegas.

So, how can you posit what will happen in the financial markets going forward when you have no hope of reconstituting the initial conditions of the past; and where even a small random perturbation in the initial conditions will dramatically affect the outcome? The answer is you cannot!

Economist Paul Samuelson once joked that prognosticators predicted nine of the last five recessions. He has a point: Volatility in markets often far exceeds – and has no relationship to – economic trends. 

Selloffs of a negative 10 to 20 percent, often called corrections, happen regularly during bull markets and economic expansions. They are sentiment-driven, fueled by fears – not reality. 

Furthermore, bear markets do not necessarily have to be associated with a recession. 1962, 1966 and 1987 exemplify this. These so-called bear markets have the propensity to be shallow and short, almost rendering their bear label questionable.

At the same time, maintaining a pragmatic financial vista should not imply any lesser degree of attentiveness on your part. Let the Street’s woeful antics be an opportunity for financial gain; take advantage of the opportunities created by those irrational panic flows of money.

Attempts at market timing are often the trait of inexperienced investors. They enter the market at a time of exuberance, only to become disillusioned when paper losses occur. The antidote of course is to never sell when the news is bad, and stocks are off their highs.

Warrant Buffett once wrote, “Why would I sell off stocks that are small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they are certain to do well. Could anyone really believe the earth is going to swallow up the incredible productive assets and unlimited human ingenuity existing in America?”

Moreover, listening to market predictions can lead you astray. As Buffett has pointed out, doing so may blur your vision to the important facts. when news commentators glibly opine on what the market will do next, Buffett says it reminds him of Mickey Mantle’s scathing comment, “You don’t know how easy this game is until you get into that broadcasting booth.”

Last week I mentioned Benjamin Graham’s book, “The Intelligent Investor ($13.49 at Amazon).” Buffett stresses the point that much of what he learned came from Graham’s book, which he bought in 1949. 

Buffett writes, “My financial life changed with that purchase. For me, the key points were laid out in what later editions labeled Chapters 8 and 20. Of all the investments I ever made, buying Ben’s book was the best.”

Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.