The problem with the old assumption is that the longer the time invested, the more possibilities for negative outliers. It is true that taking higher risks may produce periods with substantial returns, but just one bad downturn can wipe out all previous gains. Risk is defined as volatility and substantial declines in value (called drawdowns). Accepting more volatility and larger drawdowns are exactly what we don’t want. It doesn’t pass the logic test. Hence, portfolio management is not about the risk/return relationship.
The successful management of liquid securities then becomes about “portfolio efficiency.” An efficient portfolio will be managed to have lower or decreasing volatility and smaller drawdowns. Low portfolio volatility and drawdowns means that the diversification is being adjusted to work in the current market environment. As a result, long-term geometric compounding of returns will be enhanced.
Hortz: Why does your current research paper focus on disproving that markets behave in a random and normally distributed pattern? What is the significance and implications of that challenge?
Hardin: These false assumptions are another example of conventional wisdom that goes unquestioned. Doing the research, you uncover that traditional “strategic” portfolio management was based on academic theory and, more specifically, established on the assumptions of a bell curve of normal distribution - that market movements were random, like flipping a coin. The probabilities of a coin flip were 50/50 heads or tails. There is no way to determine which way the next flip will go.
Remember, modern portfolio theory and most of the “risk/reward” metrics used in portfolio management today are based on the assumptions from the bell curves’ elegant equations. The academics have been teaching basically the same thing for the last 50 plus years. They are responsible for many of the market assumptions that most of today’s portfolio management methods were built on.
The problem is that the bell curve is lousy at predicting the size and frequency of the market’s “outliers.” What are “outliers? In this case, outliers are low probability – high impact events. Some daily outliers can be extreme. For example, the markets can experience 4th, 5th, 6th standard deviation events. These market trading events are so unlikely, that a single occurrence should only happen once in several hundred years.
The truth is, and what our research shows, is that large daily market outliers occur more frequently and can be much larger than what the bell curve would predict. In addition, outliers tend to occur in groups over short periods of time. The combination of all these factors provide statistically relevant evidence that markets are not random nor equally distributed. In other words, it is impractical to use the same mathematical method, based on the same assumptions used to predict the probabilities of a closed system, like flipping a coin, to try to predict and calculate the wide possibilities of the trading ranges in the markets.
The most significant conclusion drawn from our research shows that the markets’ movements are not random nor equally distributed, but instead will experience extended periods of high volatility with large drawdowns as well as periods of low volatility with small pullbacks or corrections. Our studies show that changes in the characteristics of volatility have predictive value. Therefore, the key to cracking the market’s code is the study of volatility.
Hortz: Tell us more about your concept of Market States.
Hardin: Through our research, we have been able to determine major patterns in the market environment over time. There are many similarities between the financial markets and weather, above the Mason-Dixon line, where there are four distinct seasons. Similarly, we have identified four unique market environments. We call them Market States. The first is a Bullish Market State. This environment has low risk and is highly efficient. It will typically limit the risk to a normal correction of about 8-12 percent. Then there is a Bearish Market State that has environments with unlimited risk for loss.