I am curious about this. It’s my impression that assets tend to become more correlated in a downturn. I’m not sure how much this, or the presence of fat tails, affects things, but their back test on at least three different countries’ data mitigates my concern somewhat.
(I don’t know how it applies to this model, but...) price movements are not normally distributed, and any model that assumes they are carries a major risk of blowing up. For example: during the financial crisis Goldman Sachs chief financial officer David Viniar infamously told the Financial Times “we were seeing things that were 25-standard deviation moves, several days in a row.”
What are the chances that a 25-sigma event strikes your investment portfolio?
We should expect a 4σ event to happen twice in our lifetime. A 5σ event occurs about every 5000 years, or once since the beginning of recorded history. A 6σ event might have happened roughly twice in the millions of years since homo sapiens branched off from the other apes. A 7σ event comes along every billion years or so, or four times since our planet coalesced out of a cloud of interstellar dust. We pass the Big Bang somewhere around the 8σ mark. At 20σ, the number of years we’d have to wait is ~10x higher than the number of particles in the universe, etc.
(which is to say, Goldman and friends’ models were disastrously, absurdly, cosmologically wrong.)
AFAIK Benoit Mandelbrot was the first to start warning people about this, and his PhD student Eugene Fama wrote his thesis on it...back in 1965! Which gives you a sense of how crazy it is that people would still try to apply normal distributions to financial markets.
Mandelbrot’s book The Misbehaviour of Markets is worth a read. I’ve also written a summary of his ideas here, in the context of stress-testing the assumptions of the ‘early retirement’ movement.
(I don’t know how it applies to this model, but...) price movements are not normally distributed, and any model that assumes they are carries a major risk of blowing up. For example: during the financial crisis Goldman Sachs chief financial officer David Viniar infamously told the Financial Times “we were seeing things that were 25-standard deviation moves, several days in a row.”
What are the chances that a 25-sigma event strikes your investment portfolio?
We should expect a 4σ event to happen twice in our lifetime. A 5σ event occurs about every 5000 years, or once since the beginning of recorded history. A 6σ event might have happened roughly twice in the millions of years since homo sapiens branched off from the other apes. A 7σ event comes along every billion years or so, or four times since our planet coalesced out of a cloud of interstellar dust. We pass the Big Bang somewhere around the 8σ mark. At 20σ, the number of years we’d have to wait is ~10x higher than the number of particles in the universe, etc.
(which is to say, Goldman and friends’ models were disastrously, absurdly, cosmologically wrong.)
AFAIK Benoit Mandelbrot was the first to start warning people about this, and his PhD student Eugene Fama wrote his thesis on it...back in 1965! Which gives you a sense of how crazy it is that people would still try to apply normal distributions to financial markets.
Mandelbrot’s book The Misbehaviour of Markets is worth a read. I’ve also written a summary of his ideas here, in the context of stress-testing the assumptions of the ‘early retirement’ movement.