Invest Like Taleb: Why Skewness Matters

Mar. 20, 2014 12:36 PM ETKO, WFC4 Comments

Summary

  • Skewness is a very important concept in finance, which measures the distribution of returns.
  • As KO and WFC demonstrate, extreme outcomes prove more important than average performance.
  • Both short and long-term investors can benefit from using skew as a screening measurement.

Anyone who has read Nassim Taleb's works knows that he is a big proponent of "Black Swan Theory", i.e. rare and sudden events that have such a disproportionate effect on performance that they supersede average performance up until that point. In his recent book "AntiFragile", Taleb uses this rather humorous yet chilling example to demonstrate the principle;

Suppose you placed your grandmother in a room with an average temperature of 21ºC. For the first hour, the temperature will be -18ºC. For the second hour, it will be 60ºC. In this case, it looks as though you will end up with no grandmother, a funeral, and possibly an inheritance.

While this example is rather extreme, it does show one important principle that is highly relevant to investing: It is dispersion around the mean that matters, not necessarily the mean itself. This is especially true for investors with a short-to-medium term focus.

Taleb was once asked by an investment house to give a trade recommendation on the S&P 500 Index. Even though he saw a 70% probability of the index rising over the next week, he held a short position which puzzled his colleagues. His response was,

In the event of the index going down, it could go down by a lot.

George Soros would have put it in this way;

It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong.

Enter the principle of skewness.

Skewness allows us to measure the distribution of a set of returns to see whether the array of probable outcomes are in positive or negative territory. If a distribution is negatively skewed, i.e. has more extreme negative returns than positive, then this means that the security is expected to post frequent small gains, but a

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