Underestimating the Risks of the Stock Market

Includes: DIA, QQQ, SPY
by: Babak

If you spend enough time trading and studying the markets you realize viscerally that markets tend to fall and fall hard much more than they rise. We got a very good example of this in the 2008 bear market where the S&P 500 index gave back in about 18 months all the gains that had taken it almost 5 years to accumulate (March 2003 to October 2007).

The theoretical framework that many people use and that which is still taught in finance classes across the globe continues to assume that returns fall into a normal distribution. While it is useful to know that modern portfolio theory and EMH are flimsy theories with no real world applications, it doesn’t help us to recalibrate our instruments to just how asymmetrical stock returns really are.

To get at that answer, the research team at Welton Investments compared the actual distribution of returns from the S&P 500 index over the past 50 years with the expected risk based on a Monte Carlo simulation. The results are shown in the chart below:

tail risk SP500 index Sep 2010
Source: Tail Risk

This study shows that investors continuously and severely underestimated negative returns. In fact, going by rolling quarterly losses of 20% or more, investors experienced 5.3 times more of these “fat tail” events than that accounted for by the expectations based on a normal distribution. That difference is huge!

Knowing this historical reality, investors have two choices: either don’t play the game (get out of stocks) or play but have a safety net handy for the inevitable fall. For now, it seems that the current batch of US investors has decided to simply not play the game. They have stopped investing in equities and started drawing down their stock holdings. But the rumor of the demise of the US equity culture is still premature.