Non-normal normality

28 Jul, 2019 at 11:38 | Posted in Economics | 1 Comment

Asset price distributions are of great practical significance for portfolio managers. Standard finance theory assumes that asset price changes follow a normal distribution—the well-known bell curve. That this assumption is roughly accurate most of the time allows analysts to use very robust probability statistics. For example, for a sample that follows a normal distribution, you can identify the population average and characterize the likelihood of variance from that average.

33331However, much of nature—including the man-made stock market—is not normal. Many natural systems have two defining characteristics: an ever-larger number of smaller pieces and similar-looking pieces across the different size scales. For example, a tree has a large trunk and a number of ever-smaller branches, and the small branches resemble the big branches. These systems are fractal. Unlike a normal distribution, no average value adequately characterizes a fractal system. Fractal systems follow a power law.

Using the statistics of normal distributions to characterize a fractal system like financial markets is potentially very hazardous. Yet theoreticians and practitioners do it daily. The distinction between the two systems boils down to probabilities and payoffs. Fractal systems have few, very large observations that fall outside the normal distribution. The classic example is the crash of 1987. The probability (assuming a normal distribution) of the market’s 20%-plus plunge in one day was so infinitesimally low it was practically zero. And still the losses were a staggering $2 trillion-plus.

1 Comment

  1. The 1987 crash was fixed quickly by backroom Fed maneuvering, likely involving promises of liquidity on demand. The Fed should sell “black swan” panic insurance up front. The Fed’s job is to quell panics; why wait until one happens? Sell explicit panic insurance now as shares in a suitably countercyclical derivative index.
    The Fed can’t predict black swan recessionary pressures, so it might as well sell insurance against black swans. Then bankers can properly hedge against panics.

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