We asked both Joe and Ron to answer this question: What are 'fat tails' and why do they matter?
In an ongoing series exclusive to ThinkAdvisor, Joe and Ron will continue to provide readers with two distinct perspectives on the same topic – one from an academic, the other from a practicing financial advisor.
In the February 9, 2018 piece, Joe's response included:
The existence of heavy tails in market returns is what makes the advisor’s role as behavioral coach is so important. Big swings in both directions — up and down — happen regularly. As a result, we, as advisors, need to ensure that we are setting reasonable expectations as to the magnitude of those swings. If we fail to do so, we play directly into a client’s impulse, which is to buy when markets are hot and sell during times of panic. Recognizing that the range of what is normal for a given portfolio is considerably broader than is modeled by the old bell curve highlights the importance of using a more reasonable process for setting client expectations.
And Ron's response included:
Applications of fat-tail modeling are pervasive in the financial world. Banks and insurance companies use it to size their capital reserves and lending requirements. Broker-dealers use it to manage margin lending. Traders use it to estimate the fair price of assets and derivatives. Portfolio managers use it for portfolio construction. If you’d like to understand how volatile your retirement portfolio could get, you should ask your advisor for a fat-tail risk analysis.
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