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30 Years’ War: more on economic volatility

February 7th, 2014

Shortly after being named state small business of the year, a firm crashed on a change in foreign exchange rates. They did not understand the intricacies of foreign exchange; they didn’t have to. These people knew their prices well and could have simply translated the impact to foreign currencies. The simple fact is that they did not look until it was too late.

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We have to provide for uncertain events in an uncertain future.[1] I am not talking about risk per se—risk is measurable, and what is measurable is usually insurable. Nor is accuracy the primary challenge here. It simply takes better foresight, the means of which are within any entrepreneur’s grasp.

Volatility is not seen as a major player in everyday decisions, but it clearly should be front and center in investment decisions. Our default approach is to accept chance without evaluating it systematically and numerically—which is to say, accepting something without actually even knowing what it is. Some would say, “I can’t plan for what hasn’t happened,” but in most cases the comment reflects an individual’s narrow experience and limited knowledge of history. Warren Buffet’s dictum offers keen insight that, though spoken to investing, applies broadly: “Investing does not require extraordinary intelligence, but it does require an extraordinary temperament.”

When it comes to bubbles and bursts, those frequent extremes of volatility, there are just a few principles which can guide temperament. In bubbles and in panics alike, prices and value (intrinsic or real) lose all connection.[2] The former is the signal to sell, the latter the signal to buy. Acting on common knowledge is not a matter of intelligence but a matter of temperament. And just possibly, since volatility is both up and down, movement in one direction is temporary and soon to be replaced by movement in the opposite direction.

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Years ago, First Bank made a large bet on the direction of interest rates. This was no gamble; it was—most likely—a legitimate hedge against risk. It was surely well within their expertise to make these calculations, and it is safe to assume that their posture was conservative and cautious. But, volatility being what it is, the market turned against First Bank’s hedge before it turned back to prove them right.

This happens frequently. Why should it be a problem? Because they closed the position after the market went against them, they missed the recovery and the benefit of their initial decision. It does not take much intelligence to recognize this issue. First Bank had that in abundance. It takes the right temperament, which as often happens, these organizations did not have. Most of the executives, the board, and 2,500 people lost their jobs.

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[1] von Mises, p. 226. There is no such thing as stability and certainty, and no human endeavors powerful enough to bring them about.

[2] Surowiecki, p. 244.