Our Obsession With Fat Tails Explained

If you spend any reasonable amount of time with Ahara Advisors you will invariably hear us say the words “fat tails” and “convexity”.  We are obsessed with those words and concepts and we thought it’d be useful to tell you why.

When we say fat tails we are referring to things that have higher chances of extreme outcomes (Amazon has increased in value by over 1000x since it IPO’d, Kodak is bankrupt).  Nassim Taleb succinctly illustrated this phenomenon by describing two lands - Mediocristan (the land of thin tailed distributions) and Extremistan (the land of fat tailed distributions).

“Mediocristan” - or the land of thin tailed distributions - are a statistician's dream.  These thin tailed distributions are all around us - like the heights of people (an 8 foot tall adult may seem extremely tall to a 2 foot long baby, but is only separated by 6 feet!).  You can easily derive confidence intervals, standard deviations, averages, etc from those distributions and a statistician can say intelligent sounding things that are in fact very intelligent and useful.  It’s great!  As your sample size increases, you quickly converge to more certainty.

“Extremistan”, or the land of fat tailed distributions, on the other hand, is a nightmare for a statistician.  These fat tailed distributions occur in many places, and anytime you hear someone promoting the “80/20 rule” - they are talking about a specific type of fat tailed distribution called a Power Law distribution.  If a distribution is fat tailed, most observations are meaningless.  You can calculate an average or a standard deviation on the data you have, and it tells you absolutely nothing about what the future holds.  In fact, it tells you less than nothing because it makes you anchor expectations around random numbers..  

But we constantly see tools that work for thin tailed distributions being applied to financial asset returns - which are most assuredly fat tailed.  Any time you see someone citing any of the below with respect to financial assets, they are applying tools that only work in thin tailed domains to a fat tailed domain.  

• Standard deviation

• Correlation

• Efficient frontier

• Linear regression

• Beta

• CAPM

It’s a form of subtle fraud, but it’s pervasive in the financial industry because it’s so easy to do.  I have done my fair share of analysis using the terms above for some of the most sophisticated investment organizations in the world.

And it’s mostly wrong and worthless.

I created Ahara Advisors in part because we know there is a better, more worthwhile way to look at the world.  It involves embracing the fat tailed reality of financial assets.   

That means you throw the statistical tools associated with Mediocristan into the garbage.  And we are left with the techniques that work in Extremistan.  

That is why our frameworks and analysis can look different.  We can only help you improve your financial life if we confront reality as it is, and not as we wish it to be.