95% are wrong

Right, enough theory (read the previous parts of this series on the Bell Curve one, two, three)…

Time for the practical stuff.

Spoke with a pal who manages about £800m. Not massive, but still lumpy.

He tells me something interesting.

‘95% of retail investors still think markets follow normal distributions. We make money from the other 95% being wrong.’

Brutal. But accurate.

So how do you position yourself with the smart 5%?

First…

Understand that portfolio optimisation based on normal distributions is broken.

Modern Portfolio Theory (the foundation of most financial advice) assumes returns are normally distributed with finite variance.

But we know that's wrong.

So what does this mean?

Traditional approach financial advisors will give you: Diversify across asset classes assuming they'll behave nicely.

Reality-based approach: Expect correlations to break down exactly when you need them most.

Secondly…

Use the bell curve for what it's actually good at - understanding relative probabilities.

While markets don't follow perfect normal distributions, they still cluster around averages most of the time.

This means…

• Most days will be boring (use this for income strategies, mean reversion)

• Extreme days will be more frequent than expected (prepare for volatility and momentum)

• The biggest moves often happen in clusters (don't assume one crash means it's over, but similarly this is why you ride your winners)

Thirdly…

Factor in skewness and kurtosis.

Skewness tells you which direction the fat tail points (usually downward - crashes are more severe than booms).

Kurtosis measures how fat those tails really are.

High kurtosis = more extreme events than the bell curve predicts.

Most stock indices show positive skewness (occasional big gains) but negative skewness during crisis periods (frequent big losses).

Fourth: Use this for position sizing, not stock picking.

The bell curve won't tell you which stocks to buy.

But it will tell you how much to risk on any given position.

If you know extreme events happen 10x more often than normal distribution suggests, you size your positions accordingly.

This is why professional traders use Kelly Criterion and similar position sizing methods that account for fat tails.

Tomorrow, I'll wrap this all up with the biggest caveat of all - and why even understanding all this still won't make you rich if you ignore the human element.

P.S. - That fund manager? He's been using fat-tail models since 2009. His worst year was still positive. Coincidence? I think not.

That fund manager also uses the concepts we talk about in the Academy.

I’m not going to pretend it’s the most complex stuff ever, but it makes money without having to do much at all.

I know that sounds like the Holy Grail, but, well it is, because that is what buying US large caps with the right process allows you to do.

Watch our latest video on this (and everything else on our YouTube).

We want you to start growing your portfolio with purpose and an understanding of why you’re doing things.

No more anxiety.

More time for you to run your business or just enjoy time doing things other than stressing over markets.

Hit reply and we can organise a chat, but we’re only taking on five people over the next month. So do be quick!

Click to read the FINAL part of the series, here.