Mispriced

From Howard Marks, Chairman of Oaktree Capital

In the years leading up to the crisis, financial engineers, or 'quants' played a big part in creating and evaluating financial products such as deriatives and structured entitites. In many cases they made the assumption that future events would be normally distributed. But the normal distribution assumed events in the distant tails will happen extremely infrequently, while the distribution of financial developments- shaped by humans, with their tendancy to go to emotion-driven extremes of behavior- should probably be seen as having 'fatter' tails.

With these three sentences, Howard Marks pretty much distilled the reasons for the 2008 financial crisis and all market routs afterwards. Modeling human behaviour using statisticial normal distribution, while mathematically convenient, is fundamentally wrong.

2023-10