Large Stock Market Price Drawdowns Are Outliers

Details Large Stock Market Price Drawdowns Are Outliers Large Stock Market Price Drawdowns Are Outliers

2000-10-03

arxiv.org/abs/cond-mat/0010050v2

J. of Risk, vol. 4, Number 2, Winter 2001/02.

Physics

Condensed Matter

Replaced with new version of 47 pages including 23 figures and 7 tables. Changes considarable

Scientific paper

Drawdowns are essential aspects of risk assessment in investment management. They offer a more natural measure of real market risks than the variance or other cumulants of daily (or some other fixed time scale) distributions of returns. Here, we extend considerably our previous analysis by analyzing the major financial indices, the major currencies, gold, the twenty largest U.S. companies in terms of capitalisation as well as nine others chosen randomly. We find for the major financial markets that approximately 98% of the distributions of drawdowns is well-represented by a stretched exponential while the largest drawdowns are occurring with a significantly larger rate than predicted by the stretched exponential: the largest drops thus constitute genuine outliers. This is confirmed by extensive testing on surrogate data, which unambiguously show that large stock market drops (and crashes) cannot be accounted for by the distribution of returns characterising the smaller market moves. They thus belong to a different class of their own and call for a specific amplification mechanism. A similar scenario is found for the majority of the company stocks analysed. Drawups exhibit a similar behavior in only about half the markets that we examined. In the spirit of Bacon in Novum Organum about 400 years ago, ``Errors of Nature, Sports and Monsters correct the understanding in regard to ordinary things, and reveal general forms. For whoever knows the ways of Nature will more easily notice her deviations; and, on the other hand, whoever knows her deviations will more accurately describe her ways,'' we propose that outliers reveal fundamental properties of the stock market.

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