Thursday, April 30, 2009

Gauss vs Pareto

The Black Swan is the state bird of Western Au...Image via Wikipedia

Lately we have heard a great deal about "Black Swans" and how the markets are acting "differently". Perhaps this is because we have been ignoring data and stuck with an incorrect simplifying assumption that markets are "normally distributed"

Here is a quick analysis of the Dow over the last 70 years. Take 5 minutes to read the article, it is amazing -- but here is the bottom line

If the markets are based on "normal" aka "Gaussian" distributions;

"A five standard deviation event should only occur once every 7000 years in a world of normal distributions. "


"It happened 73 times over an 80-year period.
" (Emphasis mine, the article is from Oct 2008)

I've not done the data analysis but I would suspect we are looking at some sort of power law. Thus Pareto, not Gauss should be driving our actions in investments.

The market is perhaps a great deal risker then we thought and conversely there are potentially greater opportunities to be found.

In the past week, I've had to rethink my password strategy and my investment strategy....

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