This week in Outside the Box, good friend and London business partner Niels C. Jensen further expands upon the fat tail dilemma I recently discussed in my "Black Swan" e-letter and why many of the risk metrics we use while in theory are useful, in application are woefully misleading. Niels does an excellent job of making the topic understandable and enjoyable to read.
Academic work in the past sixty years from the likes of James Tobin, William F. Sharpe, Eugene Fama, Black, Scholes, Merton, built upon modern portfolio theory and risk management introduced by Harry Markowitz in his now famous paper 'Portfolio Selection,' in the Journal of Finance. Central to all the aforementioned academic work is the assumption that returns are normally distributed, in a Gaussian or bell-shaped curve. If returns are not, then risk management tools such as value-at-risk, become meaningless at precisely the time when you most need risk measurement tools to work! The crux of the matter is a great many finance practitioners today assess investment risk in such fashion, oblivious to the assumptions, and thus, the models shortcomings. The solution you might ask? Niles suggest that it likely lies in Power Law Distributions.
John Mauldin, Editor
Outside the Box
Wagging the Fat Tail
The Absolute Return Letter, October 2007
The Old Lady barks
As far as intellectual honesty is concerned, statements do not come much bigger, in particular when aired by a senior member of staff of one of the world's leading central banks. To have the Old Lady of Threadneedle Street openly admitting that not everything that goes on in financial markets every day is entirely comprehensible…