RETIREMENT GUIDE

2005

How the Finance Gurus Get Risk All Wrong
BRAINSTORM 
By Benoit Mandelbrot and Nassim Nicholas Taleb sales. Out of a million submitted manuscripts, a handful account for the bulk of book sales. One percent of the U.S. population earns close to 90 times what the bottom 20% does, and half the capitalization of the stock market (close to 10,000 companies) is in fewer than 100 corporations. In other words, we live in a world of winnertake-all extreme concentration. Similarly, a very small number of days accounts for the bulk of stock market movements: Just ten trading days can represent half the returns of a decade. The economic world is driven primarily by random jumps. Yet the common tools of finance were designed for random walks in which the market always moves in baby steps. Despite increasing empirical evidence that concentration and jumps better characterize market reality, the reliance on the random walk, the bell-shaped curve, and Your money is at risk. No matter what you’ve put it in—stocks, bonds, derivatives, hedge funds, houses, annuities, even mattresses —there’s always the chance that you could lose it or miss out on a bigger opportunity somewhere else. Anyone who would tell you otherwise is either a fool or a huckster. Then there are those who do warn of risk but package it into a simple numerical measure that seems to put it within manageable bounds. They’re even more dangerous. Your mutual fund’s annual report, for example, may contain a measure of risk (usually something called beta). It would indeed be useful to know just how risky your fund is, but this number won’t tell you. Nor will any of the other quantities spewed out by the pseudoscience of finance: standard deviation, the Sharpe ratio, variance, correlation, alpha, value at risk, even the Black-Scholes optionpricing model. The problem with all these measures is that they are built upon the statistical device known as the bell curve. This means they disregard