Investing can be a confusing pursuit because it requires that we deal with certain level of cognitive dissonance.
On the one hand, we are told that one of the keys to financial success is specialization. Excelling in a single pursuit is supposed to bring with it the rewards of accomplishment over and above what those less dedicated have achieved. This is a bedrock of the notion that hard work pays off.
At the same time, we live in a world of uncertainty. We can be blindsided by events out of our control, or even our ability to anticipate them. So, we are told to diversify.
Balancing these two ideas can sometimes seem an almost insurmountable task.
One of the fundamental concepts of training to become an astronaut is to "maintain an even strain." Even though astronauts are learning to function in a highly specialized manner, they are also taught to be prepared for any unanticipated events.
This is what investors must do as well.
For instance, when I worked for Merrill Lynch 20 years ago, I used to play golf with an associate who had a zero handicap. His game was phenomenally consistent, to the point of being dull. What was most interesting was that he owned no drivers, only irons. He teed off every hole with an iron, no matter how long it was. His drives were shorter than everyone else's but were always down the middle, and he always won.
As a Marine stationed at Camp Lejeune in North Carolina, I would go swimming at Onslow Beach. There were regular shark attacks so we had to be extra careful because that beach was deserted. If anyone was attacked, getting him back to the base would be difficult. One of our friends, not worried about sharks, always went into the ocean first. We would wait for him to stay out there a while and then follow. I was a lean, mean fighting machine back then, but I had never been to shark-fighting school, and I wasn't keen on receiving on-the-job training. Thankfully, nothing ever happened to any of us.
I bring these examples up because maintaining a balance -- an even strain -- between specialization and diversification is something that needs to be done consciously and actively. That balance is determined as much by individual ability as by external factors. The point of balance is dynamic and fluid.
In thermodynamics there is a concept known as the Triple Point, the point at which a substance may exist as a solid, liquid and gas at the same time and in the same place. If you've never seen it, it sounds nonsensical. Think of watching ice boiling.
Nevertheless, all substances have a triple point and it is achieved through a combination of temperature and pressure. If you observe a substance in its three phases simultaneously and you do not realize the environment is being controlled, your senses will think that it is magic. You won't be able to sense the temperature or pressure from outside the environment as an observer.
But if you know that this is a controlled state and know how it is achieved, it's logical. It's physics. It's nature.
The laws of thermodynamics may be applied to other natural and manmade systems, including economies, as well as financial and capital markets. (I have written about this before here and here.)
The capital markets of the world are currently experiencing external forces by way of monetary and fiscal intervention that have never before been tested, either in theory or in practice. I don't know what will happen, and neither does anyone else, including those responsible for applying those monetary and fiscal forces to the world's capital markets.
Right now, prudence mandates that investors position themselves defensively and remember that the first rule of making money is not losing it. I'll address those defensive strategies soon, but you can brush up on the topic here in the meantime.
