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Investing Uncertainties in the World of Fat Tails

Posted by Larry Doyle on August 3, 2010 1:26 PM |

There is little doubt we are living through a period of great uncertainty. There are a wide array of vastly diverging opinions as to what our future economic landscape entails. How often have you felt that people with dramatically disparate outlooks on the market and economy each encompass a number of cogent points? I have felt that sensation numerous times. What is the key variable in each and every opinion and assessment? Timing. When things occur is often more important than what actually occurs.

The expected timing of events leads many to believe that we are living through a period with elevated tail risk, or more succinctly fat tails. In layman’s terms:

What Does Tail Risk Mean?
A form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution.

What are the uncertainties in an investing world expecting increasingly fat tails? Mohamed El-Erian addresses five critically important points on this topic in writing in today’s FTUncertainty Changing Investment Landscape:

1. First, investing based on “mean reversion” will be less compelling. Even though flatter distributions with fatter tails have means, the constituency for mean reversion investing will shrink as those means will be much less often realised in practice. A world where the realised return rarely equals the expected valuation creates a bigger demand for liquid, default-free assets; it also lowers the demand for more volatile asset classes such as equities. These shifts are already taking place.

2. Second, frequent “risk on/risk off” fluctuations in investors’ sentiment are here to stay. Investors, based on 25 years of rules of thumb that “worked” during the great moderation, thought they knew more about the distribution of risk than they in fact did. This led to overconfidence during the bubble. The crisis reminded investors that these rules of thumb are less useful, if not dangerous.

With declining confidence in a reliable set of investing rules, markets have become more susceptible to overreactions to daily news and, are, therefore, more volatile. Just think of the number of triple-digit days in the Dow.

Moreover, because of the complex and broader involvement, real and perceived, of governments in the economy, separating policy signal from noise, and execution versus intent, has become as important as – but harder than – forecasting the macro data.

3. Third, tail hedging will become more important. An understandable consequence of the crisis is less trust in diversification as the sole mitigator for portfolio risk. We are already seeing increased investor interest in tail hedging, though the phenomenon is still limited to a small set of investors.

I had this conversation just yesterday. How does one protect against a potential sharp spike in interest rates when the immediate concern in the economy and markets is fear of deflation, which is pushing rates lower? Ask me, if you care to know. Hint, buy cheap volatility.

4. Fourth, historical benchmarks and correlations will be challenged. In this new “unusually uncertain” world, many investors will need to fundamentally rethink the design of benchmarks and the role of asset class correlations in implementing their investment strategies. The investment industry is yet to give sufficient attention to this.

No surprise. The industry wants to maintain the same styles, strategies, and benchmarks which did little for overall investment performance in the first place. These tried but no longer true approaches may work for the industry, but are they working for you the investor?

5. Finally, less credit will be available to sustain leverage and high valuations. Even apart from the inevitable response to regulatory actions aimed at derisking banks, a world of flatter and fatter distributions will reduce available supply of leverage to finance trades and balance sheet expansion.

This is not just because extreme bad scenarios “melt down” positions but rarely “melt up”. Even with a balance among good and bad scenarios, the provider of leverage does not benefit from the fatter good tail, but faces greater likelihood of loss with the fatter bad tail.

Investors had 25 years to get comfortable with the great moderation. Its end poses challenges that extend well beyond policy circles as it fundamentally undermines the rules of thumb that served so many investors for so long. The sooner this is recognised, the better.

This article was co-authored by Richard Clarida, global strategic adviser at Pimco and professor of economics at Columbia University, and Mohamed El-Erian, chief executive and co-chief investment officer of Pimco

We are living in a brave new world of investing. These points are extremely well written and should be incorporated while managing one’s own investments.


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