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.

Why Dave Ramsey is Wrong (Dave Ramsey Lie #1)

Many financial "gurus" like Dave Ramsey advise their clients to "Buy and Hold"; buy investments regardless of current market conditions and hold them for a long period. My personal favorite flavor of Buy and Hold is Dollar Cost Averaging where you pretend you didn't overpay for a particular investment.
Other advisers say to invest in actively managed portfolios with the (poorly thought out) idea of beating the market. Still others recommend investing in indexes that attempt to follow one or more of the popular markets and take advantage of the market's positive bias.

They are ALL wrong

They are wrong because they are either intentionally dishonest, or more likely, willfully ignorant.

 

What does a hedge fund manager do?

 

Imagine someone has a million dollars in stock. They want to protect their million dollars. So they "hedge" their million by buying an investment whose value is inverse to their stock. They could buy a Put option on their stock, and if the stock goes down, the option goes up. They can exercise the option and gain roughly the amount they lost on the stock. But the option itself has a cost. The hedge fund manager conducts these transactions for the stockholder, and in many cases they are the "Market maker"; the one who sells the stockholder the option.

This scenario IS a Zero Sum Game. Someone gains, someone loses. It sounds like a bad deal for the stockholder (it is), but more importantly, it's a very dangerous game for the hedge fund. Sooner or later,  hedge funds collapse. 
In the real world, hedging is not limited to options, futures, and futures option. The Now Even Bigger too-big-to-fail firms create derivative instruments so complex even they can not decipher them at times.*

The Financial Sector

 

There is no doubt some people make money in the financial sector. We all hear of the success stories. But we seldom hear of the millions who lose. That's just human nature, the winners are celebrated and the losers are forgotten. But the winners all have one thing in common - they have an edge or angle. Where does the wealth of the multi-billionaire hedge fund managers come from? Does it come from growth? Added Value? No, the majority comes from the losers. That isn't to say the economy is Zero-Sum; it isn't. But economic growth can not account for all of the wealth accumulated by the top winners.

The Unpredictable Market

 

The US stock market has dropped in excess of 40% five times in the last 80 years. None of these declines were predicted mathematically. In fact, According to the models used by financial advisors, those declines were impossible. Impossible as in even one of them could not happen in billions of years. But they happened. I explore the reasons why in other posts.

As a result of this phenomenon most (all?) successful managers destroy more wealth than they have ever created.  

This wealth destruction happens because investors entrust successful managers with more money as they become more successful. The few managers who make money do so not because they are highly competent, but because they are simply lucky with favorable timing.

Why Dave Ramsey and most all other so-called experts are wrong.

  

Financial experts fail their clients by not taking into account or informing their clients of the true nature of risk. Whatever their favorite advice, they always discount risk. They happily plod along, advising their naive clients, and some of them make outstanding returns. Then something like Black Monday happens and all the gains they previously made are wiped out. But, the expert shrugs his shoulders and says that's life, no one could have seen that coming. 

No one could have seen that coming. 

And that's exactly the point. Because they can not properly quantify the risk, they ignore it. Because of this omission, investors are guaranteed to always lose unless their execution timing is exactly right. We know that is impossible. 

This exact phenomenon has been recurring over and over since markets have were invented. And it will continue.

There is a better way. 


* This was an aspect of the so-called Housing Bubble in 2008. Investment banks fraudulently created derivatives so complex they could not decipher them. The government stepped in, and they nor the contractors they brought in could not decipher them. In the end, taxpayers paid off the investment banks and their insurance companies the amount they claimed to have lost. A real-life example is a poker game, where one person wins all the money on the table. Then the government comes in and repays all the losers whatever they claimed to have lost -with no proof.