Monday, May 5, 2008

Returns are anything but normal

Much of modern finance and risk management is built on the concept of efficient markets and the "bell curve" or symmetrical normal distribution. However, out in the real world things are a bit different. Over the years many have treated the so called "black swan" events as something that is an anomaly. But when you consider that the economic and political frameworks that comprise our world are severely flawed, black swans should come as no surprise at all. Boom-Bust cycles are the norm and extreme events should be expected, especially in light of the monetary system that we have in place. Make no mistake, there will be more financial bubbles, and extreme events in our future.

In the context of investing, the return distribution of a hedge fund graphically shows what the returns of that hedge fund would look like over time. For the most part, the risk and return distributions of hedge funds are different from the normal distribution. This should come as no surprise. How the assets are allocated within a portfolio is what accounts for most of the variability in the returns of that portfolio. And these funds operate within the context of a flawed economic and monetary framework.

Despite my distaste for applications of the symmetrical normal distribution, it does provide an opportunity to compare what certain types of hedge fund strategies entail with respect to risk and reward. Most investors do not pay any attention to the skewness and kurtosis that a particular strategy produces in its return distributions. If these two terms sound unfamiliar, do not worry, the concepts they represent are easy to understand and a brief explanation will make them clear. In future posts I will briefly explain what some of these terms mean, as these concepts can help in understanding the risks and rewards of the various money management strategies.

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