Normal Accidents in the Stock Market

Deep Survival by Laurence Gonzales is one of the best books I’ve read over the past few years. it’s a mixture of unbelievable stories of survival, bravery, stupidity, adventure, and the psychology of how humans react under pressure situation.

Gonzales introduced me to the book Normal Accidents by Charles Perrow while describing complex systems:

Perrow’s Normal Accidents, first published in 1984, is a work of seminal importance because of its unusual thesis: That in certain kinds of systems, large accidents, though rare, are both inevitable and normal. The accidents are a characteristic of the system itself, he says. His book was even more controversial because he found that efforts to make those systems safer, especially by technological means, made the systems more complex and therefore more prone to accidents.

This is one of the most perfect descriptions of the stock markets I’ve ever read.

And it’s a good reminder considering the year we’ve had in stocks in 2018. The S&P 500 has experienced two separate 10% drawdowns this year. That hasn’t happened since 1990. There have been 12 (and counting) 2% or worse down days. That hasn’t happened since 2011. I’m sure there are plenty of things that haven’t happened since 2008 or 1999 or 1987 or 1973 or 1929 as well.

The thing is the stock market is not broken when these things happen. The stock market is normal when it’s acting abnormally. Things that haven’t happened happen all the time. We just notice them more now with the firehose of information we’re hit with on a daily basis.

That’s why a ridiculously calm year in 2017 can be followed by a ridiculously volatile year in 2018.

Perrow details the story of the Apollo 13 space mission that went wrong, which was depicted in the movie of the same name starring Tom Hanks. Jack Swigert (played by Kevin Bacon in the movie) said after they got home, “nobody thought the spacecraft would lose two fuel cells and two oxygen tanks. It couldn’t happen. If somebody had thrown that at us in the simulator, we’d have said, ‘Come on, you’re not being realistic.’”

Complex systems such as the financial markets invite what seem like unrealistic outcomes at times, but craziness in the markets should be thought of as normal. And trying to completely eliminate risk when dealing with the markets is a futile exercise because risk never completely goes away, it just changes shape. Perrow cautions against this when he wrote:

Risk can never be eliminated from high-risk systems, and we will never eliminate more than a few systems at best. At the very least, however, we stop blaming the wrong people and the wrong factors, and stop trying to fix the systems in ways that only make them riskier.

It might be easy to think to yourself, “I don’t understand how markets could rise 7%, then fall 10%, then rise 13%, only to fall 10% again all in the same year.”

This is how things work in the stock market.

As Perrow says, “no matter how effective conventional safety devices are, there is a form of accident that is inevitable.”

Further Reading:
Market Earthquakes

Now here’s what I’ve been reading lately: