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Managing Volatility and Loving It

 November 30, 2012 12:35 PM

(By Frank Holmes) The stock market can be a volatile place, which is why I often remind investors to "anticipate before you participate." To be profitable in investing over the long-term, I believe you must manage your short-term expectations. 

Nassim Nicholas Taleb's article in the Wall Street Journal, which was adapted from his new book, Antifragile: Things That Gain From Disorder, helps readers think differently about volatility. He argues that we "need things that gain from volatility, variability, stress and disorder."

A few years ago, our entire investment team thought his work was so vital to asset management that we all read his best-selling book, The Black Swan: The Impact of the Highly Improbable. In this latest essay, he builds on the black swan theory to introduce us to his powerful concept of "antifragility." Whereas the word "fragile" means something has a tendency to break, as in glass or ceramics, the opposite of fragile, which means durable or robust, doesn't quite capture this idea.

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Rather, antifragility describes things that thrive and improve with volatility, stressors and uncertainty. In a Library of Economics and Liberty podcast, Taleb used an example of mailing a box of champagne glasses. On the package, you write "fragile," with the hope that the glasses would arrive at their destination unharmed. This is what he indicated as the "lower bound" of fragile.

The upper bound—the antifragile state—might mean that instead of 6 glasses delivered, 8 would arrive. Or the glasses would arrive stronger in some way, or it would be like Greek mythology's Phoenix, where "you shoot it and it comes back," he says.

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One application of antifragility is what certain stresses do to our physical and mental well-being. In the podcast, Taleb says, "If you spend Christmas vacation in a space shuttle, you'll come back with diminished bone density." Instead of giving your bones a rest, they actually become weaker when not used. But, with the right amount of stress, research shows the human body improves.

In the WSJ, he explains this concept has applications not only in our physical lives, but also in our socioeconomic life. To that end, he lists five policy rules so that we can "establish antifragility as a principle." Taleb writes:

"Modernity has been obsessed with comfort and cosmetic stability, but by making ourselves too comfortable and eliminating all volatility from our lives, we do to our bodies and souls what Mr. Greenspan did to the U.S. economy: We make them fragile. We must instead learn to gain from disorder."

I believe investors too have been obsessed with seeking stable investments and exiting out of equity funds, making our portfolios potentially more fragile. Taleb brings to light a valid idea that many investment managers have understood for years: In global markets, one can gain from volatility.

Read the article now.

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