Saturday, March 31, 2012

Mispricing risk

The thesis is that given fat-tailed (power law) distribution of returns, stocks are a loser since the standard modern portfolio theory is based on normal distributions of returns. You lose when you use the normal distribution to price when you should be using the fat tail distribution.

The basic problem with stocks is the vulnerability to catastrophic (fat tail) loss. In other words, you get wiped out every now and then.

If you hold stocks over a long period, and get wiped out only once or twice, you might recover. But if the markets are particularly volatile and the wipe outs become more frequent, you can't recover to beat the bond fund performance in the same period.

So "stocks for the long run" is only going to work going forward if the markets are exceptionally calm compared to what they have been over the last few years. I just don't believe that's going to happen.

It doesn't help that the community of people who invest in stocks tends to be crammed with risk seekers, and the bond people are risk averse. So the stock people "forget" their losses and vividly remember their gains, along with getting a thrill out of every move up or down, which is inherently addictive. This makes accurate pricing of risk even harder.