August 4, 2005

Black Swan effect – Fat outliers / Why EMT varies from reality

EMT – Efficient market hypothesis has been debated to death. There are people who swear by it, atleast in the weak form.

One area where EMT differs from reality is in its modeling of outliers, rare events or black swan (This is the term used by Nicholas M Taleb).

To get a better understand of this topic, I have been reading the book – Fooled by randomness – by Nicholas M Taleb. He uses a lot of real life examples to explain some very complex concepts.

Some ideas which have remained with me are

- Black swan or Rare events or Outlier events happen more frequently than one would think so (drawback of the EMT ? )

- The EMT models the market by normal distribution, which does not take account of these outlier events. Hence you find these spectacular hedge fund blow up like LTCM where a rare event takes the fund down

- People under estimate chance in life and attribute it to skill (in investing too)

- Human mind is not designed to be rational, especially in the area of finance and we tend to make emotional suboptimal decision

- The pain of loss is 2-2.5 times more than the pleasure of gain. As a result, if one has the tendency to check his portfolio too often, it could have a negative impact on the performance ( if one were to act irrationally based on the short term performance )

- Most of the studies on long term performance of stocks / mutual funds have a survivorship bias due to which the performance appears better than it actually is (for ex: the current sensex does not have all those companies which were a part of it and went bankrupt or got knocked off)

A good book and a must read !!

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