I came across an interesting article which talks about the 3 s.d( standard deviation or sigma) moves in financial markets. You know the kind of outlier events which are expected only to happen once in gosh..like 10 years, 15 years as per all the statistical models and supposedly the risk management we have built into our models should let us take corrective action on time. That the markets have tendency to revert to mean.. so actually you can bet against an abnormal movement..hope to revert it to mean and make some decent chunk of cash!! Nice strategy, only that these don’t work when you have an outlier event!!
Turns out these outlier events happen more frequently in financial markets then you are made to believe. Do you think the collapse of LTCM ( Long Term Capital Management) was a relatively isolated event? Well think again, it has been happening with amazing regularity. The top financial institutions like Citibank, Country Wide, Merry Lynch and who can forget Bear Stearns- writing of bad bets to the tune of billions of dollars!!These companies wiped out years of their profit in couple of quarters. Being a Mechanical engineer I have relied on 1 s.d , 2 s.d, 3.d even 6 s.d for years and these are pretty reliable indicators of quality control. It is just that when you apply the same thing to financial markets, it may not hold up….the investment managers have to be ready for any eventuality and playing defensively is the only way to survive these markets in the long term. My mantra..be ready for the outlier events and if possible profit from it..one of the reason I believe more in the trend following philosophy of the technical analysis of the markets then anything else.
Yes the markets have the tendency to revert to mean 99 out of 100 times, but when they don’t ..watch out for your head being handed in these markets. Wall street is littered with such carcasses, and yet we keep saying, hah it’s an outlier event..can’t worry much about it. Get real..get defensive..expect the unexpected..you survive! Otherwise you are another Citibank in the making!!

>I came across an interesting article which talks about the 3 s.d( standard deviation or sigma) moves in financial markets. You know the kind of outlier events which are expected only to happen once in gosh..like 10 years, 15 years as per all the statistical models and supposedly the risk management we have built into our models should let us take corrective action on time. That the markets have tendency to revert to mean.. so actually you can bet against an abnormal movement..hope to revert it to mean and make some decent chunk of cash!! Nice strategy, only that these don’t work when you have an outlier event!!
Turns out these outlier events happen more frequently in financial markets then you are made to believe. Do you think the collapse of LTCM ( Long Term Capital Management) was a relatively isolated event? Well think again, it has been happening with amazing regularity. The top financial institutions like Citibank, Country Wide, Merry Lynch and who can forget Bear Stearns- writing of bad bets to the tune of billions of dollars!!These companies wiped out years of their profit in couple of quarters. Being a Mechanical engineer I have relied on 1 s.d , 2 s.d, 3.d even 6 s.d for years and these are pretty reliable indicators of quality control. It is just that when you apply the same thing to financial markets, it may not hold up….the investment managers have to be ready for any eventuality and playing defensively is the only way to survive these markets in the long term. My mantra..be ready for the outlier events and if possible profit from it..one of the reason I believe more in the trend following philosophy of the technical analysis of the markets then anything else.
Yes the markets have the tendency to revert to mean 99 out of 100 times, but when they don’t ..watch out for your head being handed in these markets. Wall street is littered with such carcasses, and yet we keep saying, hah it’s an outlier event..can’t worry much about it. Get real..get defensive..expect the unexpected..you survive! Otherwise you are another Citibank in the making!!