This page has been archived and commenting is disabled.
Guest Post: “Fat” Tails
Submitted by John Galtier
“Fat” Tails
To be clear from the start, the finance world is one of the most
counterintuitive forums for intellectual discussion that has ever
existed. The arena is touted as attracting the best and the brightest,
while time after time, thought revolutions and advancements are borrowed
from other fields, or worse, financial academia. “Rainmakers” are loath
to admit that they do such things, but they consistently borrow,
repackage, and reiterate ideas they have adopted without just citation.
Mimicry and imitation are par for the course and there is a simple
explanation….
WHEN TRYING TO MAKE MONEY YOU ARE BETTER OFF BEING WRONG DOING WHAT
EVERYONE ELSE IS DOING THAN BEING RIGHT EXECUTING AN INDEPENDENTLY
DEVELOPED THESIS.
Making money is an objective task, either one succeeds or fails.
Results are easily testable and outcomes are binary. A trade or
investment matures or is closed in the black or red. A trader has never
ended up permanently on the “street” (no pun intended) as a result of
losing money on a popular trade. People in finance are incentivized to
follow the herd. Behavioral economists have studied this idea in-depth
and can shoulder the burden of explaining this phenomenon much better
than I, so I’ll leave the rest to them. The herd is often blamed for
causing the overshooting and mass panics that cause “fat” tails. What I
suggest is a different dynamic at play that the ”godfathers” understand.
Divergent minds have opined that security returns do not follow
standard distributions, maybe belonging to a different subset of
statistical reference. Power distributions explained option pricing all
those years ago and some have looked to it to explain security returns
again. As love does, maybe the markets have some logic that reason
cannot grasp. No matter the paradigm used to explain security returns,
it is clear that large price movements occur more frequently than any
statistical measure predicts and the problem is not outmoded models or
animal spirits.
The histograms statisticians use to encapsulate security returns do
not do justice to the way in which securities are priced. Prices are
necessarily predicted on expectations of the future and as the future
comes to fruition and time marches unrelenting, prices move. The events
of each day confirm or refute assumptions analysts have made in order
to establish bids and asks in the parlance of the market. Therefore, it
is not the price movements which must be statistically examined, it is
the events which drive prices. Every second different cataclysms
threaten to derail world markets. imagining a plausible event that could
take place tomorrow that would crush AAPL’s fortunes is not so
difficult.
Tomorrow’s WSJ Cover: “Foxconn’s Chinese Workforce Decimated by Biological Attack”
As the largest component supplier for AAPL, this news would
undoubtedly cause a devaluation deemed impossible by most statistical
models. Billions upon billions of events transpire everyday that
effect security prices and if those were histogram-ed in terms of their
affect on security prices, the results would not be indicative of “fat”
tails, but rather an extremely wide universe of possibilities. The fact
that one or two of these events end up taking a disastrous course does
not suggest fat tails, just a limitation imposed by our human brains and
relatively unrefined computing skills.
If the reader is still unconvinced, consider the average day of a GS
employee. Aside from being modern-day whipping boys (that are well
compensated on a lash for lash basis), each one knows an insular
factoid that could, combined with another viewpoint, result in a very
compelling case for market manipulation, fraud, collusion, etc. Perhaps
it would not even take a meeting of the minds. The point is, all it
would take to ruin GS’ valuation in a manner inconsistent with
statistical models is one well written letter to the SEC (assuming the
old boys network failed to quash litigation, of course).
Viewed from this framework, it is surprising wild movements do not
occur more often. HFT’s aside, plenty of factors collude to move
markets. The flattening and cross-pollination of the world threatens to
push volatility even higher. As systems become more reliant on one
another, the universe of events affecting a given security’s price
expands. The need for insightful and prescient risk mitigation is
growing and the successes and failures of many businesses will rely on
this thankless task more and more.
Tails are not becoming “fatter”, the histogram is just growing to
include more events. The author’s personal fear is that this
complication of the world is not just rendering modern statistics
useless, but the whole approach to modern investing. Money managers have
strayed further from fundamentals than in previous thought cycles.
Value dislodgements of the severity of the GFC have traditionally pushed
investors back to the fundamentals and conservatism that create real
wealth. Instead of propping up a failing system, it may be the case that
CB’s have sanctioned market timing and speculation as real forms of
growth.
If this reckless behavior continues, fundamental investors, the
“engine” of growth in a properly functioning economy, may not be given
the chance to allocate the patient capital needed to sustain growth and
combat unnecessary volatility. The leeches (market timers and
speculators) that rely on fundamentalists to maintain the sanity of
prices and their movements will control the market and values will truly
become baseless. For all the ramblings of Zerohedge prophets and gold
stockpiling crazies, values are still relatively attached to
fundamentals. Actions of central bankers threaten to give speculators a
mandate to create a true fiat system where values and prices are only
limited by the availability of ink and paper.
»
- 7676 reads
- Printer-friendly version
- Send to friend
- advertisements -
A chart for you all:
http://img59.imageshack.us/img59/3185/rut280611.jpg
(Which in graphic form keeps in mind the Fed's 3rd mandate to get the Russell 2000 to 36,000, the Bernanke Put, etc. etc., all of which just about make any fat tail risk completely irrelevant.)
You have much belief in the Bernanke my friend...I can see his force inside you...
To be honest, it's the chart I believe in.
The reasons why all come later. In this case some say QE3, others say that the economy will really start to grow in the second half of 2011, etc. etc.
Who knows? I'll wait and see, and in the meantime I'll play high probability scenario TA setups. (Add: which DO include failures if and when they happen.)
Booyah, bitchez :)))), that chart is invalid, we going much higher, keep shorting..13500 on the DOW zooming in. By the way that Double Deep BS you are talking about not even sizeble correction as Both
S&P and DOW hold above 200 MA.. Keep whining and adding to your shorts.
"FAT Tails"
Phat Tails?
Volatility anyone?
Volatility has been dropping dead, I'm myself got hedge in VIX
call Options, and it's pretty much loss.. Will wait couple more weeks
and dump it at loss.
"The point is, all it would take to ruin GS’ valuation in a manner inconsistent with statistical models is one well written letter to the SEC (assuming the old boys network failed to quash litigation, of course)"
Totally false---well, except for the your innuendo at the end. GS OWNS the SEC, they OWN the government----you don't bring charges up against those criminals and have them stick, EVER.
When will you people understand GS runs our country----they own our government and thus own us. You live in the most corrupt system ever known to mankind and it is tightly controlled by an oligarch of corrupt assholes who should all be rounded up, brutally beaten, and then shot for the crimes they have committed against humanity. If nothing else, they should be tried for treason and terrorism, the problem is those who would try them including our military are OWNED by them, so hang it up people, they own you and nothing is going to change that because all we get are more "it might be fair if" or "it is fair if", or the "democrats" or the "republicans"----face it people, the criminal bankers run this country, they own the media, they own government, they own the corrupt police force, they own the military, and by extension, like it or not, THEY OWN YOU!
And what was the crap you were spewing about "allocation of capital"-----are you serious? Markets do what GS says they do ----get it?
You nailed it!
The rest of his drivel is just BS!
values are still relatively attached to fundamentals
This statement goes against the entire concept of value investing, or investing based on fundamentals. If values are attached to fundamentals there's no entry point for fundamental investors. Psychology is a huge part of the market regardless of whether you're a fundamental investor or hyperactive speculator.
I think we can appreciate that quote in its full context.
For all the ramblings of Zerohedge prophets and gold stockpiling crazies, values are still relatively attached to fundamentals.
bwahahahahahahahahhaha
best laugh of the day
Over the last 3 years we have effectuated a complete de-coupling of financial instruments from the underlying economy. Earthquakes are now transitory. A plunging economy matters little. If all of Main Street got swallowed up in a sink hole, that too would matter little. Because the markets, particularly stocks, have simply become a proxy for the health of the TBTF financial institutions.
If their money line from the government gets cut off, or if there's an insurrection, then the market will be worth in the neighborhood of zero. Short of that the market will rise in direct proportion to the size of further bailouts and sink in their absence.
Bernanke's quivering lip says we have "fat tails" wagging the dog.
Value! You say Value?!! 100's of trillions of derivatives waiting to toast your valueless rear? Yes, it is a problem.
But one might have noticed that stopping the insanity is not going well at all. To regulate anything is to destroy the "animal spirits" striking a blow against free enterprise and the freedom to rob and pillage.
The very groups that want to bury the Bernank want also to bury rational markets or econ. Not to defend an Austrian like Bernank, but within his outlook, he is at least trying.
The Bernank an Austrian???
I think you are confused oldman.
Bernank is not a pure fruitcake, er Austrian. Hoover made some very deflationary, defunding the nation, moves. Bernank did see that fallacy, but evolved the helicopter theory, just flood the system with money and let animal spirits take over. Keynes was much the same, but it was to be directed to long term projects if possible, and was to be paid back. Bernank not so much on pay back as animal spirits would do that.
The Neo Austrian, Laffer era, is beyond all econ but essentually a method to concentrate wealth. And it works.
"WHEN TRYING TO MAKE MONEY YOU ARE BETTER OFF BEING WRONG DOING WHAT EVERYONE ELSE IS DOING THAN BEING RIGHT EXECUTING AN INDEPENDENTLY DEVELOPED THESIS."
I think this is robotrader's mantra...
robotrader's and every MD on Wall Street's methodology
zeroHeads will sail right thru snobbish social darwinism masquerading as an intellectual discussion of the finance world while belittling mimicry and imitation.
heluva camouflage!
The natives will contemplate motives of the missionary after dinner. Doing Gods work to the unwashed masses is so noble there are only one percent left. Sums up the article for the apex predators.
Did you say "Chemtrails....
Ya, they sure bombarded my area today too.....
The author may do well, to research terms, before throwing around with them. In this case, the author has very little understanding, yet uses fancy terms all the time.
FYI: If a number has more than two possible values, then it is not binary. And if a result is not a binary value, then it certainly is not binary. Nope, one not either succeeds or fails.... one may succeed a lot, succeed little, break even, fail a bit, fail big, and much more.
The rest of the article is saturated with more of such bullshit, hidden behind fancy speak that may look intelligent, but actually is quite dumb.
Can't argue with the fucking chart can you? Still it sucks that nothing makes sense but the chart is the chart.
You got it:))).. I can smell Dow/S&P shorts BBQ
keep adding, and writing and whining.. Cannot fight the FED. Period.
And don't f*ck with Bernank
cause if he'll get mad, - QE3, tick -- tack... tick --tack..
Ah, yes, Greeny. The Dow has skyrocketed 5-6% since January 1st. And WTI oil has stagnated, only rising 2-3%. Gold and silver in double digits.
Keynes said it was better to fail conventionally than to succeed unconventionally.
In medicine and finance the risk and punishment are higher for unconventional failure than conventional failure, even if you are sure ahead of time you face conventional failure or mediocrity in your endeavor.
Mavericks just become targets and their failures are judged more harshly than an equivalent level of failure by someone more conventional
stagnation of the hivemind, they will die without the addition of new elements which allow them to cope with newly discovered threats.
Look you have bid markets supported by monetary cartels. everyone knows this, very, very hard markets to make money in, because 1. you can't hedge, 2. you need to levarge up on low liquidity meltups.
But, the doomsday trade is very near, because we have the early signs of sovereign liquidity crisis and even if the print oil/commodities prices will suck up incomes, profits, savings, cause riots/turmoil etc
Greece is the lead in to the EZ meltdown, market is overprcing yes vote
The greeks will vote no, otherwise Athens will burn
Consider that inside information: Creeks already voted "YES",
watch for confirmation tomorrow morning
And then we'll probably see some "Sell on the News" reaction.
"Taking profits just in case"..
So you are realize that Greek population
are less than New York City or Moscow City
in that matter. Can few unemployed punks affect world wide
economy? Be my guest and speculate..
if i remember correctly arch duke ferdinand was taken out by a few unemployed punks.. so yes, they could be the catalyst which brings down the current order.
Greece is just the tumor. It does in fact get much worse. Remember that it is the combination of Fiat and Politicos.
Strawberry fields forever?
Yeah, sorta like that.
How is it that somebody is a "leech" if he buys from somebody else selling? Because his/her time horizon is shorter than the smatest-guy-in-the-room?
Sounds to me like he lost money on a trade. Boo-fricking-hoo.
I'm not even close to being a 'finance guy', hell, I only understand the world and markets better than 99% of non Zh'ers, which unfortunately isn't saying much. What I am gifted with is an ability to sniff bullshit from five miles away. I never really understood that this ability was a gift or unusual. I always ASSumed that everybody else did the same thing.
I loved this guy's post. I believe that it is brilliant (if not a bit late). Marla was far more perceptive in that she screamed it from the rooftop long ago.
Maybe I'm misreading this but the takeaway from this guy's post for me is that acknowledgment of the FACT that we no longer have free markets/that we truly have been corralled into a central planning farce is further settling into the 'hive'?
This fact is bigger than most realize (I suspect). What it really means is that you have now lost the last bit of your dignity and Liberty. You are no longer free.
Does that matter to the statistically average 'citizen'? No, because they have not been free for a very long time. But now it becomes 'mainstream' that even the ZH crowd is being squeezed out. Without the ability to make rational trade decisions then WTF do you do?
Counter trend doesn't seem to work especially well these day's, heading away from the herd makes me feel like a fool when I consider all the money I could have made but have not.
I'm still covering shorts on the EUR/USD from 400 pips ago. Remember, I admitted I'm not a finance/market player. I have been trying to learn however and sincerely this manipulated bullshit is a suckass and disheartening way to become educated. What I'm learning so far is that the elite really do run the world and that they are as competent as were all the previous failures.
In other words...Failures. These asshats in charge behind the scenes today are just the same asshats at a different time.
Is making us feel like throwing in the towel part of the strategy? I'm thinking yes, it must be.
They could not possibly think that we might suddenly, enmass, rally around their transparently corrupt crap , could they?
Anyway. Thank you Tylers for another great read.