Using a Fat Tail to Describe Stock Market Risk

“If you want to make an impression at a board meeting or a Congressional hearing these bearish days, make a harrumphing noise and employ the figure of speech now sweeping the economic world: ‘But what about the fat tail?’”

The quote came from a weekly NY Times Magazine column called “On Language.” While the year was 2009, it is especially relevant today.

Fat Tails

To understand a fat tail, we can start with a bell curve and height. As economist William Nordhaus explained, most women will measure between 58 and 70 inches with the mean at 64 inches. Using three inches as a standard deviation, an 11 foot woman would be placed 23 standard deviations away from the 64 inch mean. Because her height is a dot where the line should not even exist, we call it a tail event. A fat tail is the unexpected event located far from the mean.

A Bell Curve:

From the Nordhaus paper on fat tails, here is a look at some from the stock market and for oil which indeed might now, at $40 a barrel, be displaying a fat tail.

From: “The Economics of Tail Events with an Application to Climate Change”

Other financial fat tails? The 23 percent Dow plunge on October 19, 1987; the 2007-2008 meltdown, the U.S. housing market after 2006.

Yesterday’s Fat Tail

The largest point loss ever, the 1089 plunge when the market opened yesterday was a fat tail event. By midday it was down 102 points but then the decline resumed. The Dow was down 588 at the close.

Our Bottom Line: Risk

Fat tail surprises can have a lasting impact because they change our perception of risk. After the 1987 crash, circuit breakers were implemented that temporarily halted precipitous trading. As for the 2007-2008 financial meltdown, couldn’t we say that Dodd-Frank was a result?