Fat Tails

EXTREME EVENTS HAPPEN MORE frequently than we imagine. Think back over the past two decades in the financial world. We had the stunning stock market rally of the late 1990s and the subsequent stunning decline, especially among technology stocks. We had the housing mania that peaked in mid-2006 and the grueling bust that followed. We had the financial crisis of 2008, with reverberations still felt today. In his 2007 book The Black Swan, Nassim Nicholas Taleb highlighted how the supposedly improbable occurs with surprising frequency—and yet folks are shocked every time.

Such extreme events suggest that, instead of market returns being normally distributed, with most years seeing middling performance, the tails of this humped-back distribution curve tend to be fat because of the surprising number of extreme events, hence the term “fat tails.” This can be seen as evidence of market inefficiency: Far from being rational, investors tend to be a little manic, becoming both overly exuberant and excessively pessimistic in response to economic and political developments. For those looking to time the market, this might make their venture seem more promising.

But fat-tail events might also be viewed as another reason for humility. Few people forecasted the extreme events that we have seen in recent decades. Given that these extreme events seem to be relatively commonplace, we should probably avoid making overly large bets on any one investment, so we don’t miss out on the next surprising market surge or run the risk of seeing our portfolio hurt by the next unforeseen disaster.

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