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What I've Learned From My Schizophrenic 401k

Three lessons from turbulent times.

stockmarket.jpgThe stock market sank yet again yesterday, as a late-day sell-off pulled share prices down another 5 percent.

It's just the latest in a series of occasionally-manic-but-mostly-depressive market convulsions. After getting so much good press for the last decade, the "wisdom of crowds" -- i.e., the combined knowledge of millions of investors -- seems pretty threadbare these days. The markets simply can't decide if it's finally time to buy, or time to keep selling. The crowd is as flummoxed as the rest of us.

Since the economic crisis is far from over, it's probably far too soon to draw firm lessons from all this turmoil. Initial reactions are like Rorschach tests, revealing more about the observer than about what's being observed. It'll take a long while for the real lessons to emerge.

Still, I can't help but think that there must be something to be learned from what markets have been telling us in recent weeks. So at risk of blogging prematurely (but hey, that's what blogs are for) here are three things I've learned, or re-learned, from my schizophrenic 401k.

1. Unlikely events are common

2. Markets don't know much

3. Unsustainable things stop

Ok, I admit that's all a little cryptic. Details follow...

1. Unlikely events are common.

Since 1997 we've been through an Asian currency crisis; the "10 sigma" (i.e., nearly inconceivable) failure of the investment firm Long Term Capital Management; the hyperventilation and collapse of the internet bubble; a presidential election decided by a handful of votes out of more than 100 million that were cast; an unprecedented terrorist attack; and the inflation and deflation of bubbles in real estate, in the stock market, and possibly in commodity markets. That's a lot of extremely unlikely events for just a little over a decade. And really, that's just a sampling, not a complete list!

But I suppose you could look at any 10-year stretch of history and find that it was shaped -- even dominated -- by these sorts of "rare" events. The reality is that unlikely events are commonplace.

There are lots of ways of understanding why the rare is so ordinary. For example: categorizing an event as "likely" or "unlikely" is often just a matter of perspective. A thousand-to-one longshot seems like it might "never" happen. But do it every day for 2 years and the odds are better than 50-50 that it'll occur. So is one in a thousand event rare, or common? It depends on your timeline: over the long haul, the longshot is a sure thing.

Ultimately, highly unlikely and unpredictable events are common, and have an outsized influence on the real world. And this leads me to thoughts of climate change and ecosystem disruption. The default "skeptical" view now seems to be that climate change may be real, but that we shouldn't worry too much because it probably won't be all that bad. Among many other flaws, this view ignores the very real chance that climate change will be even worse than many people now imagine. Perhaps the doomsday scenarios are unlikely. But that's the point: given a few centuries and enough human obstinance, we may find that even the most unlikely events can come to pass. Time and again, mistaking the unlikely for the impossible has been our undoing.

2. Markets don't know much

marbles.jpgTake a couple hundred typical third graders, ask them how many marbles there are in a jar, and the average of their answers will be surprisingly accurate. Any one third grader may not know that much; but combined, they can beat most grownups.

There's a very respectable & well-researched view that "the market" is basically like a crowd of third graders: individually flawed, but collectively wise. On this view, there's no one individual -- not even someone like Warren Buffett -- who can consistently do a better job of assessing a company's future prospects than the market as a whole. Together, hundreds of thousands of investors pool their knowledge, incrementally bidding up or down the price of a stock based on dispersed clues and impressions about a company's value and the economy's prospects. The market, by this view, is something greater than the sum its parts: by assembling hundreds of millions of pieces of data, it creates predictions that have an uncanny, almost eerie accuracy.

Well, so much for that theory. After a 25 percent market drop, the crowd's "wisdom" from a couple months ago looks downright foolish.

Setting snark aside, I'm quite sympathetic to the view that markets can aggregate data about people's preferences and economic prospects. But only to a point. Markets are also complex mind-games. They have so many bizarre feedback loops that they often spin solid data into wild and foolish guesses, producing results that every participant in the market finds absurd. (Paging Pets.com!) That's especially so when traders get caught up in the "game" of predicting other peoples predictions, rather than in paying attention to long-term value of whatever it is that they're buying and selling. Just so, markets can also be manipulated, and market failures of all sorts are surprisingly common. In the end, these sorts of problems may be an inherent part of markets, rather than remediable flaws.

For me, this is all the more reason to think of a market as a fallible tool. If conditions are just right, that tool can sometimes be harnessed to good ends. But it's hard to tell when conditions are right, and when they're wrong. And even at its best, a market is never an oracle, much less an arbiter of justice; its "decisions" should carry no moral weight. Anyone who pretends otherwise deserves everything the market's thrown their way in recent weeks.

3. Unsustainable things stop

This one is easy: if something can't go on forever, it won't. That applies to asset bubbles as much as to climate change and oil addiction. Sooner or later, all of these bubbles burst. It's not a question of whether we'll stumble, but of when -- and of how far we fall when we do.

The only sensible thing to do when you see something that's clearly, inherently unsustainable is to do your best to stop it before someone gets hurt. On the way up, the party seems like fun; but the better the party, the worse the hangover.

So it's been with housing and easy credit; so it will be in many other arenas. Take energy: despite the high prices we've been experiencing, I don't think we've quite hit the hangover phase yet. Oil prices are easing right now, and if history is any guide, cheaper oil will mean more consumption, and a continuation of the cycle of addiction we've been pursuing for most of the last century. Who knows how long it'll take until the oil party's really over. But geologists aren't lying when they say that, at the rate we're going, we'll start running low on oil and other fossil fuels sooner or later. It's when, not if.

So if we don't start preparing ourselves for it, the eventual (and inevitable) tightening fossil energy supplies could mean a hangover that will make today's economic storms look like a period of relative calm. Unsustainable things will stop, by definition. Once we come to grips with that fact, we can start planning a smoother and more gentle transition to a set of expectations, and way of life, that can really last.

[Stock market image courtesy of flickr user artemuestra. Marble image courtesy of flickr user mrs eNil. Both are distributed under Creative Commons licenses. My sincerest apologies that I neglected to credit Mrs eNil in the original version of this post -- she has many lovely photographs on her flickr photostream. It's definitely worth a visit.]

This article originally appeared on The Sightline Institute's blog, The Daily Score.

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