Sunday, May 31, 2009

How Much of an Outlier Was 2008?

. Sunday, May 31, 2009

Annual Market Returns 1927-2008, cap-weighted NYSE/Amex/Nasdaq:

Eugene Fama and Kenneth French posted this graph along with historical analysis of equity market returns, the equity risk premium, and equity market volatility. It is a very informative post, and basically shows that for financial markets 2008 was especially volatile, and it was an extreme event, but was not completely over the edge. Such a large negative return has a roughly 1.18% chance of occurring (if you assume a normal distribution, which isn't perfectly accurate). Statistically, this means that such an event should occur roughly once every 85 years. The last time it happened was in the early 1930s, or seventy-some years ago.

The graph actually surprises me: I'd expected much less movement in general. The mean year-by-year market return has been 11.39% since 1927, with a standard deviation of 20.75%. That's a lot of movement. Fortunately, as we can tell just by eye-balling the graph, the trends are largely positive.

This sort of historical context is important to remember when discussing policy. Markets have had catastrophic collapses before, and they will again. But recovery is basically assured, and overreactions look silly in due course. The next time someone talks about a "crisis of capitalism" keep this graph in mind. That does not mean that it is impossible to improve the system to lower the probability of a recurrence of these sort of events. But tweaks on the margin are one thing; over-hauling the system in response to a rare event is quite another.

(updated for clarity)


How Much of an Outlier Was 2008?
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