Expecting Fat Tails (Mawer)

Expecting Fat Tails

by Jamie Hyndman, Mawer Investment Management

The beginning of the calendar year is forecast season in the investment industry. Numerous financial organizations poll investment managers like ourselves and ask for our opinion on a wide variety of measures. Questions such as, “what is your expected annual return for the TSX index?” are standard fare.

Invariably, when the survey results are released to the investment community a month or so later, they are effectively all the same. The answer to the above question for example is almost always that the TSX is expected to return somewhere between 5% and 10% this year.

What’s interesting about this is that it’s almost always wrong. In the last 50 calendar years, the TSX returned between 5% and 10% on only 8 occasions, or roughly 16% of the time.

So what’s going on here? Why are investors lead to believe this fallacy?

The error being made is the assumption that investment returns are normally distributed in the short-term. They are not. There are unpredictable, extreme events that occur in the capital markets on a very regular basis that trigger the typically human reactions of either fear or greed. These inevitably lead to market booms or crashes. The resultant short-term return distribution therefore is one that has “fat tails” at either end, not the nice symmetrical bell shape we yearn for.

Unfortunately, the assumption that market returns are normally distributed is widely used throughout the investment industry. Many investment advisors will cite the long-term average of about 8% as a reasonable expectation for returns in the coming year. Then the advisor will be surprised when their client comes in for a portfolio review meeting in December and is mad that the markets were down 15%! I would say the client has every right to be mad. What the advisor should have said was that, “market returns in any given year are extremely variable, so you must be prepared for anything in the short-term.”

Awareness of the wide variance in investment returns will go a long way in setting reasonable expectations and delivering positive client experiences.

Jamie Hyndman

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