Thursday, March 21, 2013

Earthquakes and the Mind-Bending Laws of Markets - Bloomberg

To summarize: markets (and earthquakes) are not "normal".

Earthquakes and the Mind-Bending Laws of Markets - Bloomberg:

"Unfortunately, centuries of science and mathematics tradition, focusing on the normal statistics of things like weights, heights, and test scores, has taught us to see the world incorrectly. It was a telling moment on April 27, 2010, when Goldman Sachs Chief Financial Officer David Viniar testified to the Senate Permanent Subcommittee on Investigations....

“We were seeing things,” Viniar said... “that were 25-standard-deviation events, several days in a row.”
In Gaussian mathematics, even an eight-standard-deviation event is expected only about once in the entire history of the universe. A 25-standard-deviation event should be expected about once every 10 to the 135th power years -- one followed by 135 zeros. Stocks over a single day typically change less than about 2 percent, so a movement of even 10 standard deviations means a movement of at least 20 percent. While normal statistics says this should happen once every 10 to the 22nd power days, market data show that it happens essentially every week for at least one of the few thousand stocks in the market. So perhaps we should reexamine our assumptions."

Don't be normal: markets, earthquakes, and life often have fat (and important) tails! 

Great article!  Thanks Dave for sending it to me!  (FYI Dave is a hedge fund manager who speaks to my class at least once a semester.)
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