Financiers earn wealth by often selling companies or individual assets based on their guidance to the roads of financial markets. Count me too guilty as charged. But far too often, as I learned in business school at Vanderbilt and earning my Chartered Financial Analyst degree, financiers proposed pure mathematical models to guide all participants. Markets were a science based on mathematical equations like physics, math, and biology. First they all agreed financial data statistically copied a normal, bell curve. However, all data challenged this assumption with significant “fat-tails.” In addition, all investors act rationally; trends in financial prices do not exist; and all information known is priced into the asset. Mandelbrot contested all three assumptions with vast amounts of financial data.
The normal, bell curve states that only 0.27% of data points are outliers. The long-term S&P 500 graph shows this assumption often proves mistaken. Notice the number of outliers defined as price movements exceeding 3 standard deviations. Notice the amplitude and clustering of these outliers. Because of these extreme outliers, fortunes can be made or loss with far greater probability than current models suggest. And as Ted Turner once said, “There’s nothing sadder than a poor person, no – there’s nothing sadder than a rich person who’s become a poor person.” Second, investors often act irrationally letting emotions impact their decisions. Just recollect the dot.com bubble. (Sometimes investors face no choice but to act irrationally as those margined to the market are forced to sell at any price to meet their margin calls.) Third, time proves incontinuous often. Assets often get halted based on news with prices adjusting 10% or more within minutes.
Incorporating the works of Fisher, Minsky and Mandelbrot, investors should question the conventional wisdom offered by today’s consultants and advisers. After the longest bull market in modern history, with rates so low and risk-taking so high, investors may think greater caution should be warranted. Fortunes have been made over the last ten years due mainly to central banks printing money. Fortunes may be lost in a matter of months based on history and real historical data. Caveat Emptor!
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