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Fat Tails & The Invisible Vulnerability Of Markets

Tyler Durden's picture




 

Authored by Michael Mauboussin, via ValueWalk.com

Fat Tails & Nonlinearity, Dec 2007

Diversity Breakdowns and Invisible Vulnerability

For he who is acquainted with the paths of nature, will more readily observe her deviations; and, vice versa, he who has learned her deviations will be able more accurately to describe her paths.

 

Francis Bacon
Novum Organum 1

The Memo Went Out

If you are involved in financial markets, you have gotten the memo about fat tails by now.

But awareness of extreme events is not enough. Thoughtful investors must understand two interrelated aspects of the market. The first is the statistical properties of price movements, including important deviations from the bell-shaped distribution. Academics, risk managers, and quantitative investors have explored this aspect extensively. Researchers recognized decades ago that the distribution of price changes includes fat tails.

The second aspect, and one often overlooked or misunderstood, is the mechanism that leads to the statistical imprint. Much of the work on the market’s statistical properties is divorced from the propagating mechanism, while traditional theories of market efficiency assume the mechanisms. Crucially, understanding the mechanism provides insight into how and why markets fail.

Our focus here is on nonlinearity. Many complex systems, including markets, have critical points where small incremental condition changes lead to large-scale effects. Researchers in both the physical and social sciences have known about these critical points for a long time; so much so that terms like phase transition and tipping point have slipped into our day-to-day language. Still, critical points throw a monkey wrench into our mostly linear cause-and-effect thinking.

Critical points help explain our perpetual surprise at fat-tail events: We don’t see them coming because the state change is much greater than the perturbation suggests. Water does not undergo a dramatic change as it drops from 35 to 33 degrees Fahrenheit, but two degrees of additional cooling changes its state from liquid to solid. Likewise, large changes can occur in markets without visible manifestation in asset price change, while small additional changes can flip the price switch.

Critical points are also important for proper counterfactual thinking. For every critical point we do see, how many were lurking but never triggered? Like water temperature dropping to 33 degrees and again rising, there are likely many nearmisses in the markets that elude our detection.

We survey three ideas: black swans and why patterns set us up for surprise; the conditions for crowds to be wise and the role of nonlinearity; and, finally, three examples of nonlinearity, including a physical system, an agent-based model, and a recent market dislocation.

Michael Mauboussin - Fat Tails And Nonlinearity

 

Don't Feed the Turkey

Nassim Taleb uses the black swan metaphor to help popularize the fat-tail idea. He defines a black swan as an outlier event that has an extreme impact and that humans seek to explain after the fact. Recent market turmoil fits the definition well.

The black swan reference reflects Karl Popper’s criticism of induction. Popper’s point is that to understand a phenomenon, we’re better off focusing on falsification than on verification. Seeing lots of white swans doesn’t prove the theory that all swans are white, but seeing one black swan does disprove it.

Taleb relates the story of a turkey that is fed 1,000 days in a row. The feedings reinforce the turkey’s sense of security and well-being, until one day before Thanksgiving an unexpected and uninvited bad event occurs. All of the turkey’s experience and feedback is positive until fortune takes a turn for the worse. Recent comments by a senior executive at one of the world’s largest banks evoke the turkey story: “Our losses [from instruments based on U.S. subprime mortgages] greatly exceeded the profits we made in this field over several years.”

Michael Mauboussin - Fat Tails And Nonlinearity

 

Here’s the point: rising asset prices provide investors confirming evidence that their strategy is good and everything is fine. This induction problem lulls investors into a sense of confidence, and sets the stage for the shock when events turn down. That nonlinearity causes sudden change only adds to the confusion.

 

Michael Mauboussin - Fat Tails And Nonlinearity

 

See full PDF here

 

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Sun, 07/19/2015 - 12:43 | 6329538 Oh regional Indian
Oh regional Indian's picture

For the record I love fat tails (in cars, old american classics).

That said, and like I said earlier, we live in a world where our old assumptions DO NOT APPLY.

There is a new normal and it is somewhere around where 6 sigma was 40 years ago.

+ the more re-hypothication is allowed legally, the more risk is pushed out, the fatter and heavier the tail gets. 

Re-hypothication and re-insurance are the two true causes of fat tail syndrome. When it cannot be insured further, it explodes and now (like AIG) the common man is the bag HOLDER! 

System can be fixed with a few common laws globally banning certain instruments.

Won't happen...

Thus, blues...happy sad...

https://www.youtube.com/watch?v=mxkHQXb5nDc

Sun, 07/19/2015 - 12:53 | 6329569 El Oregonian
El Oregonian's picture

More like fat fails...

Sun, 07/19/2015 - 13:00 | 6329586 ebworthen
ebworthen's picture

"Is it live, or is it Memorex?"

Sun, 07/19/2015 - 13:06 | 6329602 kaiserhoff
kaiserhoff's picture

Good piece and well founded on Taleb's work.  Two additional points.

Strictly speaking, statistical analysis (bell curves) should never be used on the stock market, because two important assumptions, independent variables and random selection never, ever apply to the way stat is used with stocks.

Second, in the age of ZIRP, all stocks tend to move in tandem, as the 'equity class' of investments.  In this environment it is much easier, cheaper, and safer the buy the S&P 500 rather than individual stocks.  So the variability inherent in thousands of stocks, is reduced to ONE,  hence enormous risk.

Sun, 07/19/2015 - 13:07 | 6329604 OneTinTrooper
OneTinTrooper's picture

For the middle class, they just shut everything down.  Then they come back online and you are worth half as much.  For the truely wealthy, public markets are just one of many places that wealth resides.  So they don't really give a fuck about black swan displacements.

Sun, 07/19/2015 - 13:19 | 6329632 Rektors
Rektors's picture

Bitcoin hitting $60 000! Now that's a beautiful Black Swan.

Sun, 07/19/2015 - 13:51 | 6329702 Big Brother
Big Brother's picture

The way the GBPJPY acted two Wednesdays ago looked like a mini-fat tailed event.  After an agreement was hammered out between Greece and the IMF/Troika, and China's politburo doing whatever it takes to limit short speculators, the bleeding ended and the pair reversed in mirror-fashion.  Black Swans are nonetheless extraordinarly infrequent and difficult to predict. 

I've listened to a fair amount of Hugh Hendry talk about an existential view of markets.  To summarize his investing philosophy:  oone can really know and the future is difficult to predict. So investing is treacherous, fraught with risk.  I sought another book.  I read Taleb's next book, which is the antidote a black swan event, "Antifragile".  My takeaway was to be hedged in things that gain (or recover, depending on your frame of reference).

I surmised to short treasuries, buy some physical precious metals, go long miners (I know, it's ugly right now); and keep some money outside a bank.  From where I am and little relative wealth I have, this is the best I can do.  This coming from a Millennial.

 

Sun, 07/19/2015 - 14:25 | 6329761 Sir SpeaksALot
Sir SpeaksALot's picture

black swan is something you cant predict, or even pretend you re predicting.

to be more precise: if you can describe a black swan before it happens - it is not a black swan.

Sun, 07/19/2015 - 14:31 | 6329787 MATA HAIRY
MATA HAIRY's picture

janet b yellen promised me a fat tail distribution...I am still waiting for that fat tail you promised, janet

Sun, 07/19/2015 - 14:38 | 6329803 Salah
Salah's picture

Israel has decided O'Bama is a mortal threat to Israel....anything can happen; be advised.

Sun, 07/19/2015 - 16:15 | 6330145 mkhs
mkhs's picture

From your lips to God's ears.

 

Excuse me; to Allah's ears.  Or Thor's ears, or Zeus's ears, or etc.

Sun, 07/19/2015 - 15:37 | 6330018 who cares
who cares's picture

What about the NYSE stopping trading for four hours due to a "computer program error" when stock prices were dropping more than 300 points?

Sun, 07/19/2015 - 21:21 | 6330824 voltrader66
voltrader66's picture

Yaaaaawn...talk about stating the obvious.

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