Almost one year ago, I warned you about extreme events known as “fat tails”. And not just in financial markets. Today I want to renew that warning:
As I see it, uncertainty is growing, not falling, as the pandemic comes to an end. The extremes of possible outcomes are rising, not falling. As we say in the business, the bell curve is widening and the fat tails are growing.
Since I made that warning, we’ve had plenty of fat tail events. Inflation soared, stagflation returned, the yen plunged, stocks and bonds crashed together and plenty more surprised us. But I never really explained what a bell curve and a fat tail is…
The idea is so important to what we do at Fortune & Freedom, and why we are able to coexist with the likes of the BBC and other mainstream media organisations, that it should probably be part of our welcome series – the emails all new subscribers get.
Over in Australia, the publisher even renamed our sister business “Fat Tail Media” given how important fat tails are to what we do. You see, we don’t compete with the rest of the media or financial world. We do something different. And “fat tails” are the best way of describing this.
But, to understand the idea, we must first look at something called normal distribution.
If we lined a bunch of people up by height and counted how many people were each given height, you’d end up with a chart that looks a bit like a bell. Lots of people are average height, less are a little taller or shorter, even fewer are very short or very tall and so on.
This is called a normal distribution. Because it turns out that it isn’t just height that conforms to the bell curve. A lot of things do. And financial markets do in many different ways.
Small moves in stocks are very common. Larger ones are rarer. And crashes don’t happen much at all. If you measure this, you also end up with a bell curve showing that the more extreme an event, the rarer it is.
But here’s the key. Crashes in financial markets happen more often than a simple analysis of the bell curve would lead you to you expect.
That’s a simplified version of why investment bank Lehman Brothers and hedge fund operator Long-Term Capital Management went belly-up. They made investments based on predictions that the stock market’s moves would resemble a bell curve.
But, every now and then, you get a severe surprise. And those surprise happen more often than you’d expect given the rest of the bell curve’s shape.
We call these more common than anticipated events “fat tails” – bulgy bits at the end of the bell curve.
Let’s back up a moment. If you presume that something you’re measuring conforms to the bell curve – the average is common and, the more unusual the event, the less common it is – then you can make predictions about the chances of something happening.
What are the chances of you meeting someone who is seven-feet tall tomorrow? You can calculate that, if you know how many people you’ll meet and information on human height distributions.
The same goes for financial markets. You can predict the probability of your portfolio rising or falling by 2% tomorrow because stock market moves resemble a bell curve.
Based on this, you can adjust your risk tolerance. People who don’t want their wealth to fall more than 10% in a given year will know what portion of their assets to hold in risky investments and in safe ones.
That’s all well and good. And, right the way through my finance degree, I waited for us to be taught about reality instead of the theory. But it never came. Despite the financial crisis ripping up the textbooks as we regurgitated their content in 2008.
2022, in turn, slew the idea of what’s risky and safe as bonds crashed instead of going up. People who held more bonds than stocks to reduce their potential losses during a stock market crash were hammered. That’s why inflation was a fat tail event for financial markets.
So, let me introduce you to a dose of reality to get the theory out of your head. A fat tail is an extreme event that is more likely to occur than the bell curve would lead you to expect. It’s not just an extreme event that is rare. It is one that is much more common than your analysis of past events would lead you to expect.
I’ve flown a lot in my life, thanks to parents who decided to live on opposite sides of the world. This caused me to gather lots of information about how interesting a flight would be. Usually, nothing interesting happens. Sometimes, something interesting happens. And almost never does something very interesting happen.
But one day, my flight went through a flock of birds. That was a fat tail event, let me tell you! Not just because it was a surprise. But because it is surprisingly common.
Returning to finance, the real issue at hand, at least one of them when it comes to fat tails, is that people use too brief a data set when they make the calculations.
For example, if you use a few years’ worth of stock market data to determine how likely a 2% or more drop in stocks is, you’ll get a very different result depending on whether you run data between 2020 and 2022, 2003 and 2007 or 2008 and 2009.
Lehman Brothers and Long-Term Capital Management didn’t run data from previous real estate crashes and sovereign bond crises, as it turned out. So, they massively underestimated how much risk their firms were taking on.
When markets stopped conforming to the bell curves that had been created based on previous trading data, the firms’ risk management teams realised they were in trouble.
The classic example of this is the turkey problem. A turkey might observe small variations in how much they get fed and calculate the likelihood of getting a smaller-than-usual meal tomorrow. Only to discover tomorrow is Christmas…
Now, eating turkey at Christmas isn’t rare. But eating turkey is. And it’s certainly high impact… for the turkey.
My point today is: don’t be the turkey, because Christmas is coming.
Fat tails – events that financial markets do not even consider to be worth considering – are far more likely than in the past. Debt, stagflation and plenty more are at extremes which raise the chances of surprises occurring to higher levels than usual.
Sure, finance has never been good at dealing with fat tails. That’s why people have short and intense careers in investment banking. The try to make hay while the sun shines, knowing their methods wouldn’t survive a snowstorm.
But that’s not my point. I’m saying that individual investors who don’t get paid bonuses to retire on and don’t use eye-watering amounts of leverage because they need to preserve their wealth even in a snowstorm should be even more prepared than usual.
Editor, Fortune & Freedom