Monte-Carlo Simulations Get ‘Fat Tails’

Given the volatility of the past two decades in the stock market, starting with the 1987 market crash and ending with last year’s 40% meltdown, investment managers and financial advisers are beginning to update their portfolio risk management systems with stress tests that account for extreme events, The Wall Street Journal reports.

Whereas standard portfolio construction has traditionally assumed a bell-curve shape, the updated models have “fat tails” that take severe market downturns into consideration and, therefore, are far more conservative than previous models.

Clark McKinley, a spokesman for California Public Employees’ Retirement System, said Calpers is considering such a model due to the fact that “we got blindsided by some developments that weren’t accounted for by the models we were using.”

Likewise, Ibbotson and MSCI Barra recently included fat-tailed outcomes in their Monte Carlo risk management software. Instead of allowing a 40% decline in the market to happen once every 111 years, for instance, it might make the scenario happen every 40 years.

But absolute-return-type mutual funds that use derivatives or other strategies to hedge against such losses incur higher trading and portfolio management fees, according to PIMCO. “You’re spending some of your upside to buy the insurance against catastrophic losses,” said Vineer Bhansali, a managing director at PIMCO.