Power law investing
Proponents of classical finance dismiss these supernormal events as freak accidents and simply discard them from theory. They seem unaware that fat tails also have a decisive influence on the central properties—variance, correlation—of return distributions.
We investigate some of the consequences for portfolio diversification and risk management.
- Investment performance is overwhelmingly determined by one-day gains and losses which classical finance deems 'de facto' impossible
- Fat tails are not only important per se: they affect the central properties of return distributions too, to the extent that classical portfolio techniques break down in reality
- The probability of those outliers cannot be dependably determined from the limited historical samples we have
- Investors and risk managers must resort to resilient heuristics rather than rigorous formulas
Performance issue 12 - September 2013
Performance is a triannual digest, dedicated to investment management professionals, which brings you the latest articles, news and market developments from Deloitte’s professionals and clients.