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. 3 Crucially, understanding the mechanism provides insight into how and why markets fail.
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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. 3 Crucially, understanding the mechanism provides insight into how and why markets fail.
Read the complete article
