A lot of people think that this last recession was caused by fat tails in the market. When they think of the market, they are generally thinking about a stock market like the Dow Jones Industrial Average or the S&P 500. Fat tails refers to a distribution of returns with more extreme points than suggested by a simplistic approach that only looks at the standard deviation and assumes a normal distribution. The below chart shows the kurtosis (The higher the kurtosis, the fatter the tail) and volatility of the S&P 500 market over the past 80 years. Click on the chart to enlarge.
Source: Palantir Finance
It is interesting to note that the returns of the S&P 500 during the downturn didn’t have fatter tails than past market meltdowns. While it is true that deleveraging and liquidity events caused some positions popular with leveraged quantitative funds to all move in the same direction and models with uncorrelated and always rising house prices banks used to asses their risk were quite unrealistic, the popular myth that quants just didn’t understand that general market returns are not normally distributed is not true on many different levels.