### Thursday, November 05, 2009

## Was 2008 Really a Black Swan Event?

No! It was just a 2-3 STD_DEV (SD) year.

Under idealized assumptions (although that is not the market), with respect to averages:

+/- 1SD covers 68.26% of possible outcomes; so 15.87% of outcomes can be above +1SD and 15.87% of outcomes can be below -1SD (ie disaster once in 6.3 periods).

+/- 2SD covers 95.44% of possible outcomes; so 2.28% of outcomes can be above +2SD and 2.28% of outcomes can be below -2SD (ie disaster once in 43.86 periods).

+/- 3SD covers 99.73% of possible outcomes; so 0.135% of outcomes can be above +3SD and 0.135% of outcomes can be below -3SD (ie disaster once in 740.74 periods).

With moderate allocation balanced funds having SD of 10-14% annualized, a "-2SD event" could cause losses of 20-28% sometime in 43.86 years and that turned out to be 2008.

With conservative allocation balanced funds having SD of 7-10 annualized, a "-2SD event" could cause losses of 14-20% sometime in 43.86 years and that did happen in 2008.

So as painful as 2008 was, it wasn't totally beyond the realm of possibilities.

Lesson then is to control portfolio risk to one's comfort zone.

Under idealized assumptions (although that is not the market), with respect to averages:

+/- 1SD covers 68.26% of possible outcomes; so 15.87% of outcomes can be above +1SD and 15.87% of outcomes can be below -1SD (ie disaster once in 6.3 periods).

+/- 2SD covers 95.44% of possible outcomes; so 2.28% of outcomes can be above +2SD and 2.28% of outcomes can be below -2SD (ie disaster once in 43.86 periods).

+/- 3SD covers 99.73% of possible outcomes; so 0.135% of outcomes can be above +3SD and 0.135% of outcomes can be below -3SD (ie disaster once in 740.74 periods).

With moderate allocation balanced funds having SD of 10-14% annualized, a "-2SD event" could cause losses of 20-28% sometime in 43.86 years and that turned out to be 2008.

With conservative allocation balanced funds having SD of 7-10 annualized, a "-2SD event" could cause losses of 14-20% sometime in 43.86 years and that did happen in 2008.

So as painful as 2008 was, it wasn't totally beyond the realm of possibilities.

Lesson then is to control portfolio risk to one's comfort zone.