Benjamin Graham described Mr. Market as a manic-depressive, randomly swinging from bouts of optimism to moods of pessimism. While equities and markets exist in perpetuity and can create wealth in the long-term, most investors don’t have the luxury of remaining invested forever. We have extensively discussed the problem of sequence-of-returns risk for investors who have finite investment horizons in our Free Float newsletters (Intro.)
A bigger problem than sequence, is the severity of low-probability events. Also called fat-tails or black-swans.
While an investor can mitigate an unfortunate sequence of returns through diversification, a market tsunami can hit all assets at the same time.
The charts show how years of returns can get wiped out in a month in the markets. While investors mostly focus on the average, the tails end up dictating their actual returns.
While using traditional statistical tools like average, std-deviation, correlation, etc. makes sense 99% of the time, they breakdown during that 1% of the time where an investor needs them to hold. This is the main motivation behind studying tail-risk events.
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