The title of this essay distills what I have come to believe will be one of the significant and enduring consequences of the global financial crisis for investors: Now and for the foreseeable future, we are in a world in which average outcomes – for growth, inflation, corporate and sovereign defaults, and the investment returns driven by these outcomes – will matter less and less for investors and policymakers. This is because we are in a New Normal world in which the distribution of outcomes is flatter and the tails are fatter. As such, the mean of the distribution becomes an observation that is very rarely realized, creating at least three fundamental consequences for investment strategy.
Getting the Tails Right
First, since the price at which investors can buy an asset will tend to reflect the ex ante mean of the distribution of returns, realizing alpha in the New Normal world when selling the asset will require getting the tails right. Selling after a left tail event is realized (or after the market gets news that a left tail event is more likely – think Greece) will likely result in big losses. Selling after a right tail event is realized (or after the market gets news that it is more likely – think J.P. Morgan shares after the conference committee vote on the Dodd-Frank bill) will likely result in big gains. On average, the investor’s returns will likely be modest, but only rarely if ever does any investor realize those average returns.
“Getting the tails right” will be easier said than done. Rules of thumb and historical correlations will likely prove to be irrelevant or, even worse, misleading guides to portfolio positioning. Examples abound: V-shaped recoveries may not inevitably follow deep recessions (as the incoming U.S. data are now confirming); tripling the monetary base may not inevitably lead to double-digit inflation (as the Treasury Inflation-Protected Securities [TIPS] market is telling us); and half-trillion-dollar official sector rescue packages may not inevitably be sufficient to address sovereign liquidity disruptions (as is reflected in Greek government bond prices). Regarding the euro, as my colleague Andrew Balls points out in a recent essay:
There are a range of possible outcomes for the eurozone. At one extreme is successful fiscal adjustment, the creation of a deeper fiscal union and the creation of a European Monetary Fund – built on the foundations of the special purpose vehicle (SPV) – to ensure that this never happens again. At the other extreme it could involve exit from the eurozone by one or more countries, and it may not be just the eurozone’s weakest members that will have to leave. It is possible that Germany may one day see the benefits of a return to the deutschemark outweighing that of European solidarity. The unthinkable has become thinkable.
Risk On, Risk Off
Second, a New Normal world is likely to be one with frequent flips between “risk on” and “risk off” days. With so much profit and loss riding on tail events and so little profit and loss tied to the cluster of outcomes near ex ante means, repositioning will likely be more frequent. This is because many investors lack conviction in their understanding of the true distribution, so that each passing day provides an opportunity to learn or unlearn how likely the relevant tail events are. Positioning for mean reversion will be a less compelling investment theme in a world where realized returns cluster nearer the tails and away from the mean.
