Based on the normal distribution, the probability of many financial ruins in the 90s would be so small that it was not worth the consideration. For instance, the chance of 29.2% of index fall was less than 1 in 10^50 But it happened on October 19, 1987, the Black Monday.
The other example took place in 1997, when the Dow had fallen 7.7% in one day. The probability of this event was 1 in 50 billion. Actually index swings of more than 7% should come every 300,000 years; however, the twentieth century saw forty-eight such days.
We can see a pattern here. The odds of financial ruin has been underestimated.
It was common in investment portfolios to calculate different frequencies of risk and reward. However, it seems like we have underestimated the risk which is the denominator. There are many ways of handling risk.
One method used in the financial markets is "fundamental" analysis. It means, if a stock is rising or declining seek the reason behind it and try to predict the stock's next move. Financial firms and newspapers try to find these reasons and sell it to us. The point is, in the real world the true reasons are unclear. The critical information needed is misinterpreted or misrepresented.
When we look back at the history sometimes threat of war resulted in fall of dollar and some other times in rise of dollar. How can we know which one is more probable?
Therefore the financial industry offered the second method: "technical" analysis. This is the art of recognizing patterns. Technical analysts try to find support points or trading ranges in the market and they can be correct at times. Although everybody else knows about support points so this method cannot be reliable and surely cannot be used for global risk management.
So something called as "modern" finance came to the picture which its followers believed prices are not predictable, but their fluctuations can be described by the laws of chance, so their risk is manageable. The bell shape (normal distribution) was introduced to this field. Also a paper called the Efficient Market Hypothesis stated in 1960s that in an ideal market the price of today is independent from the price of yesterday.
These were the tools that economists used to analyze the market and its probability of risk.
Mandelbrot argued that the old financial tools were based on two wrong assumptions : Price changes are independent and they are normally distributed. Researchers shows that many price series have a memory, which means today actually influences tomorrow. I am not talking about the seasonal or weekly trends, but "long memory ". A policy that a company regulates today will have an influence on the company a decade later.
There are some rules that can help lessen our financial vulnerability:
- Markets are risky: Extreme price swings are common in financial markets. This fact can be useful for computer simulations to test wild "what-if" scenarios.
- Trouble runs in streaks: An experienced trader knows that the first 15 minutes of trading each day are important. Because in those wildest moments, the rare crises of the financial world are made. Also, they know that a wild Tuesday may well be followed by a wilder Wednesday.
- Markets have a personality: The external factors, such as wars and peace, come and go, affecting prices. However, the significant process by which prices react to news does not change.
- Markets mislead: Patterns are trap in financial markets. The power of randomness can create some patterns, misleading people that they can predict these markets.
- Market time is relative: Professional traders often speak of a "fast" market or a "slow" one, depending on the volatility at that moment. Many believe that markets operate on their own "trading time" distinct from the linear "clock time".