The global stocks roller-coaster of recent days reminded me of three lessons I learned many years ago as an investor in emerging markets. If well understood and applied, these precepts can turn unsettling volatility surges into longer-term opportunities.

1. Long periods of market calm create the technical conditions for violent air pockets. Until last week, the most distinctive feature of many market segments was historically low volatility, both implied and realized. Although several economic and corporate reasons were liberally cited for this development (including the convergence of inflation rates worldwide and eternally supportive central banks, as well as healthy balance sheets and synchronized growth), an important determinant was the conditioning of the investor base to believe that every dip had become a buying opportunity, a simple investment strategy that had proven very remunerative for the last few years.The more investors believed, the greater the willingness to “buy the dip.” Over time, the frequency, duration and severity of the dips diminished significantly. That reinforced the behavior further.The economist Hyman Minsky had a lot to say about the phenomenon of prolonged stability breeding complacency as a precursor to instability. This phenomenon is reinforced by the insights of behavioral finance and can lead markets to embrace paradigms that ultimately prove unsustainable and harmful (such as the idea well more than a decade ago that policy making had totally overcome the business cycle, and the notion that volatility had been flushed or hedged out of the financial system). Continue Reading →