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Sunday, June 05, 2005

Mandelbrot and Investment Risks (from The Prudent Investor)

Caution: discussion of statistics ahead.

According to Yale Professor Emeritus Benoit Mandelbrot, much of current established financial theory is on shaky ground. He has a book out, titled "The (Mis)behaviour of Markets: A Fractal View of Risk, Ruin and Reward." In it, he claims that markets are much riskier than we think, since much of current theory is based on the idea that market prices change continuously according to the bell shaped curve we call the normal distribution.

In actuality, he says, market prices show far more discontinuities (jumps) than a normal distribution would assume. As a result, these large price movements contribute a lot more to portfolios' performance than the theories currently used (like the CAPM) would allow for. As an example, in the 1980s, 40% of the total investment gains over the period came fromjust 1/2 of 1% of the days.

So, there's a lot more chance of getting really hosed (sorry, he calls it "the chance of ruin") than you might think, and you should hold a much more diversified portfolio over a wide variety of asset classes (i.e. not just stocks and bonds, even if they're in different sectors or countries).

Hat tip to The Prudent Investor for the link.

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