The world is not normal, yet universities continue to teach our young students the wisdom of Markowitz and Sharpe which brought us modern portfolio theory and, more specifically, the capital asset pricing model. Garbage In, Garbage Out, as they say. One of the fundamental assumptions behind modern portfolio theory is that asset returns are normally distributed random variables. I suggest you take a glance at chart 1 below. The bright (smooth) blue line depicts a perfect normal distribution. The darker (uneven) blue line represents actual equity market returns over the past couple of decades. Even the untrained eye can see that the return profile of US equities fairly closely matches that of a normal distribution with the exception of large negative returns. They have come about more frequently than one would or should expect .
Chart 1: The Return Distribution of Equities is Non-NormalRead it at Advisor Perspectives
Source: “Global Volatility Outlook 2012”, Barclays Capital.Note: Histogram of 3-month overlapping returns of S&P500 since 1990
Dont Fight the Last War Lessons from the Battlefields of Risk Management
By Niels C. Jensen
Jensen’s letters always provide wisdom in managing risk. Turning to investing, the next bubble to bust may be Asia.