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Everyone Continues To Underestimate Stock Market Risks at Trader’s Narrative





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If you spend enough time trading and studying the markets you realize viscerally that markets tend to fall and fall hard much more than they rise. We got a very good example of this in the 2008 bear market where the S&P 500 index gave back in about 18 months all the gains that had taken it almost 5 years to accumulate (March 2003 to October 2007).

The theoretical framework that many people use and that which is still taught in finance classes across the globe continues to assume that returns fall into a normal distribution. While it is useful to know that modern portfolio theory and EMH are flimsy theories with no real world applications, it doesn’t help us to recalibrate our instruments to just how asymmetrical stock returns really are.

To get at that answer, the research team at Welton Investments compared the actual distribution of returns from the S&P 500 index over the past 50 years with the expected risk based on a Monte Carlo simulation. The results are shown in the chart below:

tail risk SP500 index Sep 2010
Source: Tail Risk

This study shows that investors continuously and severely underestimated negative returns. In fact, going by rolling quarterly losses of 20% or more, investors experienced 5.3 times more of these “fat tail” events than that accounted for by the expectations based on a normal distribution. That difference is huge!

Knowing this historical reality, investors have two choices: either don’t play the game (get out of stocks) or play but have a safety net handy for the inevitable fall. For now, it seems that the current batch of US investors has decided to simply not play the game. They have stopped investing in equities and started drawing down their stock holdings. But the rumor of the demise of the US equity culture is still premature.

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6 Responses to “Everyone Continues To Underestimate Stock Market Risks”  

  1. 1 Bo

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    So VIX futures is a effective tool to protect my portfolio from intraday crash in stock market that exist on ‘’Fat Tail”.

  2. 2 Avi

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    nice post… its interesting when you combine that fact with what behavioral finance has found that people will often dont compute the correct probability outcomes for their investment holdings. They choose to hold on to large losses with a slight possibility of gain while conversely they sell winners with a slight possibility of losing…

  3. 3 WimpyInvestor

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    Great research finding.

    Any idea how the conditional probability distribution looks following an unexpected tail event?

    In other words, let’s isolate all the instances that landed in the “orange zone” and map out the subsequent rolling quarterly returns?

    Do you still get the same tail risk probabilities going forward (after one tail risk event has already occurred)? or Do you get somehow get back to a Normal Distribution?

    Since we already experience the 2008 tail risk event, I’m wonder if what “conditional probability distribution” to use going forward for the next 10, 20, 30 years?

    Thanks!

  4. 4 SpencerFrater

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    Don’t investors have a third option - to sit tight in equities, riding out the falls (and rises) over a long period of time?

    This should provide a reliable 5% return, (or more in a developing market), which a basic timing strategy (such as increasing your exposure after an event like October 2008) could increase to 7-8%.

    This is better than avoiding the market altogether and settling for risk-free returns in the order of 2-3%.

    OK, you still require that long period of time to reduce the risk - but that’s fine for your pension or retirement fund!

  5. 5 Mike McDermott

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    Creating a safety net is EXACTLY what many of the great traders with extraordinary track records have done.

    This year’s excellent book The Invisible Hands by Steven Drobney paints includes an interview with an especially talented trader who uses dynamic hedges to curtail the left side of the return tail - while still staying in the game for the outperformance in good years.

    Of course no hedge is costless, but if you subscribe the the EMH you really shouldn’t be trading afterall - that’s kind of like a Nun teaching sex-ed… (http://mercenarytrader.com/2010/06/the-astonishing-hypocrisy-of-efficient-market-theorists/)

    Underestimating the risks will likely always be part of the stock market approach - but properly MANAGING that risk is what allows traders to truly outperform.

    ~Mike
    http://MercenaryTrader.com

  6. 6 Greg Cook

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    I posted an article in January, which came to similar conclusions, although not as eloquently illustrated by your chart. I demonstrated that Monte Carlo simulation using a standard normal distribution for stock returns predicts a better than 90% survival rate over 35 years for a retirement portfolio with a 50% allocation to stocks. Adjusting the distribution to account for the tail effects you mentioned reduced the survival rate to less than 75%.

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