Power law investing

Article

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.

Executive summary

  • 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. 

Performance issue 12
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