Morningstar - Q2 2020 - 7

Letter From the Editor

Mandelbrot Was Right

Jerry Kerns

"In the 1960s, I found that the bell-curve
models concerned only a part of nature. [They]
failed to apply to the real world of finance....
I wrote a great deal on this topic, but clearly, I did
not speak loudly or convincingly enough."
Benoît Mandelbrot, 2009
Benoît Mandelbrot was a world-famous mathematician and polymath but not an economist.
Yet, he made one of the most profound discoveries
in finance: Changes of asset prices can
be extreme.
This might sound like an obvious observation.
But standard financial economics suggests
otherwise. Widely used theories such as the
capital asset pricing model and Nobel
laureate Harry Markowitz's mean-variance model
assume that extreme returns-positive
or negative-rarely, if ever, happen. Mandelbrot,
and his student Eugene Fama, found that standard
models of returns grossly underestimate
the prominence of extreme events in the real
world, especially on the negative side.
Mandelbrot was largely ignored by mainstream
finance. (Fama abandoned Mandelbrot's approach
and went on to develop the efficient-market
hypothesis.) The quote above is from a discussion
about the global financial crisis moderated
by Morningstar researcher Paul Kaplan for the
February/March 2009 issue of this magazine.
Mandelbrot was 84 at the time and died in October
2010. With a hint of regret, he acknowledged
that his ideas never caught on. Today's standard
Monte Carlo simulation models continue to
understate the odds of extreme returns. But as we
experience yet another devastating market crash,
we know Mandelbrot was right.

tend to do the same. And when a crash occurs,
investors perceive it as a unique event that
no one could have seen coming. In that same 2009
issue, in the throes of the worst financial
crisis since the Great Depression, Kaplan wrote
an article that dispelled this notion. He looked
at market return data back to the 1920s and
showed that market crises regularly occur and that
eventually stocks recover and go on to new
heights. We nailed the timing of the article, by the
way; the market reached rock bottom in March
2009, right as subscribers were getting the issue.
For this issue, we asked Kaplan to revisit his article.
This time, he had data all the way back to the
1870s. He found that market crashes of 20% or
more occur in the U.S. on average every nine years
("Black Turkeys Everywhere," Page 37). This
seemingly "black swan" event we're experiencing
isn't a black swan at all. In fact, it's just a regular
occurrence, more like your run-of-the-mill
"black turkey"-a term that reminds us that the risk
of crashes is the price that we pay to earn
long-term returns above the risk-free rate. Kaplan
then dives into the Mandelbrot-Fama model
and shows how it fits the historical returns on the
stock market indexes of 33 countries. ("Fat
Tails and a Gaggle of Economists," Page 42). In this
article, he explains why the world went with
Markowitz and Fama, not Mandelbrot. Back in that
2009 conversation, Roger Ibbotson, an expert on
capital market history, admitted that returns
experience random jumps, to which Mandelbrot
responded, "I'm very pleased to [hear] that,
after many years of denial, discontinuities are now
allowed into mainstream economics." As we
go through yet another "discontinuity," maybe the
industry will finally take Mandelbrot to heart.

Underestimating the risks of investing is not
restricted to financial economists and investment
practitioners. During bull markets, most investors

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Morningstar - Q2 2020

Table of Contents for the Digital Edition of Morningstar - Q2 2020

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Morningstar - Q2 2020 - CT1
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Morningstar - Q2 2020 - Cover1
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Morningstar - Q2 2020 - 1
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Morningstar - Q2 2020 - Contents
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