The Seductive Nature of Fat Tail Distributions

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Market prices have shown us that certain companies have benefited from the way society has changed during the COVID-19 crisis. A group of tech-focused businesses, referred to as FAANG stocks, have seen their share values increase in ways that are challenging to put in perspective.1 As my friend and colleague Gene Fama said recently:

These firms are entirely different from one another. And they are the end result of a process that started back maybe before 2000, where companies involved in various aspects of tech, of which there were hundreds, or maybe thousands at that point, were all competing to boil to the top. And these five or whatever boiled to the top, so we tend to concentrate on them and forget about the fact that most of this industry died. If you were trying to pick out who were going to be the winners back then, you probably have an empty sack at this point. What we have now are basically the ex post winners. But going ahead, we do not expect them to have 20% returns, never mind 34% returns or whatever the number is. That’s out of the ballpark as far as an expected return goes.

But despite Gene’s warning, stocks with 34% returns are pretty alluring to investors. This is because of what I think of as the seductive nature of fat tail distributions. The term “fat tails” is used to describe outliers in stock returns. Research has shown that there are many more extremely good and extremely bad returns than might seem reasonable. Fama wrote about fat tails in his dissertation 50 years ago, and the other day he said:

I wrote my thesis on outliers in stock returns, so it’s not surprising that we see them. They’ve been around with relative high frequency for as long as there have been data.

His research partner, Ken French, continued:

I want to pick up on a point Gene was making, which is, returns are made up of two parts: there’s the expected part; if you were looking forward, that’s your best guess of what’s going to happen; and then there’s the unexpected part, the surprise, the deviation from your best guess. If we were to look at a relatively short period—and to most people, what Gene, David, and I would think of as a relatively short period is a long period—people are fooling themselves about what they can infer from random stock returns. And the best example I have right now…FAANG stocks.

Ken and Gene have spent their careers trying to figure out what expected returns are. Yet when we’re meeting with clients, we’re largely talking about unexpected returns, whether extremely good or extremely poor. FAANG stocks may make up part of a well-diversified portfolio. But a well-diversified portfolio is much more than those five stocks. That’s why it’s so important not to fall for the sirens singing songs of fat tails.


FOOTNOTES

1 Facebook, Amazon, Apple, Netflix, and Google (a subsidiary of Alphabet) are often referred to as the FAANG stocks.

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