The real-world challenges of dealing with fat tails—the higher frequency of extreme returns than a normal distribution implies—have received a lot of attention since the market crashed in 2008, and rightly so. Modeling asset prices based on an assumption of normally distributed performance runs into trouble when Mr. Market throws a hissy fit. As a result, a lot of models crashed and burned during the Great Meltdown in late-2008. We’re all older and presumably wiser now. But while it’s tempting in the post-crash era to allow non-normal distribution modeling to dominate portfolio analysis and design, reality is a bit more nuanced.
Continue reading →