Operating an investment portfolio today is like running a nuclear power plant, asserts Bernstein’s Inigo Fraser-Jenkins. The systems being managed are complex and “tightly coupled,” with “normal accidents” being part of the complex systems and process. The question is, when the inevitable “mistake” occurs in the form of a market crash, is it an operator or system error?

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Complex systems in a highly interconnected setting are likely to experience "normal accidents"

The most infamous nuclear accident in the US was the Three Mile Island incident. Considered the worst US nuclear incident, there was no actual loss of life and nuclear contamination to humans in the area was similar to that of a chest X-ray, according to the American Nuclear Society.

From the standpoint Fraser-Jenkins, however, the incident offers investors a teaching opportunity. Three Mile Island is one of several famous calamities where the management of highly complex systems where quickly interconnected components all can play a role in creating a disaster.

In the Three Mile Island incident, a leak in the coolant system caused pumps to automatically stop, which automatically shut down the steam turbine. In efforts to elevate the problem, the reactor core emergency feed water pumps came on. The problem was the operators were unaware the system valves had been left closed. They verified the pumps were on but did not know they were pumping water.

Much like looking at market indicators, the operators had 1,600 lights on the control panel, with one of the lights at issue obscured by a repair tag. “The operators had no reason to suspect a problem there, it did not fit into their mental map of what was happening,” Fraser-Jenkins wrote, noting that signals on the control panel were showing conflicting information. In the rush of the moment, they had to determine which indicator to believe. “In deciding upon their course of action they had no way of knowing that water in the earlier emergency system was not flowing.”

Initial blame quickly focused on the human operators. But were they, like today’s portfolio manager, to blame?

Failure is part of the process with complex systems

Researcher Charles Perrow termed the Three Mile Island incident a “normal accident,” where failure is a function of the system itself and accidents should be expected.

There are three attributes of a normal accident that can apply to portfolio management.

The Three Mile Island system was “tightly coupled,” where processes happen so quickly there is literally no way to separate one from the other. Once a chain reaction is unleashed, there is not a methodology to “freeze” the action and consider different causes of action. This was evident in the 2010 Flash Crash and, it can be argued, the 2008 financial crisis.

The second attribute is that the systems can be complex, with one malfunction impacting many components of the overall system. The third attribute is that a “normal accident” occurs when the systems are just too complex for operators to understand in real time.

Translated into portfolio management, Fraser-Jenkins does not look at this as an excuse for poor performance but rather an explanation of what can go wrong. But he says today’s globally connected financial markets are undoubtedly “tightly coupled,” where information can quickly spread and create a chain reaction.

In today’s portfolio construction, the complexity is apparent, where the same investments can perform multiple roles. If an investment fails in one role – a defensive stock fails on a relative basis during a market crash – it can impact the entire hedging regime.

Even MIT’s Andrew Lo, when testifying before Congress in the wake of the 2008 market crash, concluded that “financial crises are normal accidents.”

Just remember this when your portfolio loses nearly half its value during the next financial crisis – and try not to throw your computer out the window.