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14 March 2017

Stock Market Asymmetry and It's Implications



The dirty little secret of mainstream financial gurus.

Do you consider yourself an investor? Do you have a 401K or Defined Benefit retirement plan? Many people’s retirement funds are professionally managed and invested directly in stocks and bonds. Even if you never directly participate in the markets, you are affected by them, and your money isn’t as safe as mainstream financial advisors would have you believe.

Everyone knows you can take a loss in the market, as we have all been reminded the past few years. The critical omission is that this is guaranteed to happen. This post focuses on stock market asymmetry and what it means for the average investor.

Below is a chart I created plotting expected performance of the stock market versus actual for the past 80 years. The chart shows the total number of years the market was within 1, 2, or 3 standard deviations.


 


The chart illustrates the positive bias of the stock market. More importantly for this discussion, is the “fat tail” at the -3 sigma point. Normal Distribution would predict a -3 sigma event 1.8 years out of 80. However, there were actually 3 years when the market lost over 29.9% (3 standard deviations). Statisticians would argue this sample is not statistically valid due to the small sample size, and this argument is correct. However, it has been shown (by others) that this asymmetry holds no matter the time period. It is true for daily, minute and even tick values.

The stock market more closely follows a Power Law distribution rather than a Normal Distribution, but almost all common stock market tools, including the Black-Scholes option pricing model, use the Normal Distribution, ignoring the greater-than-expected risk of substantial losses. This is the dirty little secret of mainstream financial gurus.

 

The fact that the market does not follow Normal Distribution (the Bell Curve), has several important ramifications.

1.    In order to realize something near the 10.95% mean, market timing must be correct. Retirees do not have the flexibility of waiting +/- 15-20 years to achieve optimal entry-exit timing. If the market is in a much-greater-than-expected slump at retirement time, you lose. Survivors of the 1929 crash had to wait 40 years to recover their losses. Who can  postpone retirement an extra 40 years?

2.    The stock market is MUCH more unpredictable than commonly acknowledged or accounted for.

3.    Most investment mangers lose more money for their clients than they make. This sounds incredible but is true. Managers make a little bit of profit each year until a >3 Sigma event occurs (at a rate much higher than expected due to Power Law distribution of the market) and they lose more for their clients than they have ever made for them. I will try to elaborate on this proof in a future post.

4.    When mainstream financial experts claim you can expect x% return in the stock market over time, they can only mean one of two dishonest things; either “over time” really means an unknown (and unknowable) variable amount of time, or; they are citing a mythical Normal Distribution market.

5.    It is interesting to note, that in the financial gurus make-believe ND stock market world, Black Monday 1987 and the 2008 market meltdown are statistically impossible. Their models do not allow for these events yet they happened.

6.    Day trading is generally considered risky and perhaps much like gambling. The main reason is because optimal market timing is so important and it is infamously difficult to achieve. For investment and retirement funds the time period is the only difference. The importance of timing is exactly the same. Therefore, investing in a long term equities fund is fundamentally no different than the shadowy world of day trading.

There are better ways to invest that greatly decrease risk.