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:
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.asymmetrical, behavioral economics, equity culture, fat tails, Monte Carlo simulation, tail risk, Welton Investments
One of the easiest and most convincing arguments that one can make right now is that US investors are abandoning stocks and flocking to the perceived safety of bonds. It is easy to point to the fund flows which show week after consecutive week of outflows for US equity mutual funds and gargantuan positive inflows for bonds.
The chart below shows the stark dichotomy in cumulative flows between equity (both US and foreign) and fixed income funds:
Since January 2007, US retail investors have cashed out an astonishing $262 Billion from domestic equity mutual funds and socked away almost $730 Billion into municipal and taxable bond funds. So it is understandable why someone looking at this chart would start to believe that the fabled US equity culture is over.
But as I wrote late last year, it is too soon to declare an end for the "cult of equities". If instead we look at the relative holdings of US equities, we see that the average US investor has still got skin in the game. The chart below shows US stock holdings relative to total household financial assets (click to see a larger graph in a new tab):
Continue reading 'Rumors About The Demise Of US Equity Culture, Premature'