Now the question is, I was already suggesting that there is an issue of outliers.

So, what do we mean by an outlier? Well, there's something, I'm sure you've heard
about the normal distribution or the bell shaped curve for random variables. The
normal distribution is a typical distribution for random variables in nature and
there are reasons to think that many random variables follow a distribution like
this. The distribution has two parameters, its mean and its standard deviation. So
in this case, I have plotted it for two different standard deviations but both a
mean of zero. So, this is a theoretical probability distribution for let's say a
return on a stock and here the standard deviation is one on this pink curve, and
it's three on the blue curve. Many random variables in nature follow this
distribution but not all of them and that's important because in finance it tends
not to follow this distribution, that we tend to have outliers or fat tails. The
normal distribution, has two tails. This is the right tail which has high values of
the random variable, and here's the left tail which is low values of the random
variable. And the height reflects the probability of getting that value. So, if
this were the distribution of returns for Apple stock, and let's say, a standard
deviation of three percent, then the probability of getting a return of three
percent is pretty good. Here's three percent, and the probability of getting three
standard deviations, that would be nine. You can see it's just about negligible,
and then I don't even show it anymore. The probability of four standard deviations
out is essentially zero. That's what the normal distribution says. The normal
distribution has been used to describe for example, human heights or human IQs or
SAT scores or, lots of things seem to follow the random normal distribution. And
you probably have become intuitive about this. If you see some random variable
repeatedly, and it's pretty much always been between say minus five and plus five,
then intuitively you start to think it can't happen, that it would be 15 because
you're intuitively trained by life's experiences. But in fact, there are other
distributions that are more characteristic of financial returns. So there's another
kind of distribution called the Cauchy distribution after a famous mathematician.
And what I'm showing here is, at 100 draws from the normal distribution in blue,
and 100 draws from the Cauchy distribution in red. Now you see the difference
between a Cauchy and the normal. The normal distribution has a kind of look to it,
you see it's going up and down about the same amount all the time, well, I'm not
saying that's exactly right. The probability that it will be 10 times the normal
change, the usual change is negligible so you never see it deviating from... It has
the kind of uniform look to it through time but with Cauchy, it also looks very
much like normal. You can't even tell them apart for long intervals of time and
then bang! there's some big positive value. In other words, the distribution under
Cauchy is fat tailed so the Cauchy looks like a normal distribution except instead
of just trailing off to zero, the distribution continues out above zero, way out.
So, you can be deceived by a fat tailed distribution like the Cauchy into thinking
that you're living in a fairly stable world whose risk I understand, but the
problem is, there are these big events that occur from time to time. The Central
Limit Theorem in Statistics says that, averages of a large number of independent
identically distributed shocks or random variables is approximately normally
distributed, but that central limit theorem assumes that the underlying shocks do
not have fat tails. So, if you're taking the average of stock market returns which
tend to be fat tailed, then your average is not a good indication of the real
average over long intervals of time because you might well have gotten a sample
where none of the fat tail outlier stocks. My friend Nassim Taleb has written a
book called "The Black Swan" which got a lot of attention. It referred to black
swan events. So you've seen a lot of swans in your lifetime, and they've always
been white, right? Have you ever seen a black swan? You might well conclude that
black swans do not exist but in fact they do exist. There are black swans and so
that's a metaphor he uses for a fat tail. Here is a plot of the normal and the
Cauchy distribution. The Cauchy distribution looks pretty much like the normal.
It's a bell-shaped curve and it trails off but there's a subtle difference, that
there are these rare very... they're not quite as rare as as the normal would
suggest. The real world puts fat tails in our lives. Here is a plot of the
histogram of daily stock price changes since 1928. And what I have, what this thing
is, how many days are there since 1928, but it's tens of thousands of days. And so
what we're seeing here is that the stock market yielded a return of, this is for
the S&P 500, or extended S&P 500 of between, I guess this is between... of one
percent with some interval around that. It did that and suddenly like 9,500 days,
it earned plus one percent one day. And then, on something like 2,500 days, it
earned plus two percent. And then on Sunday like 800 days, it earned plus three
percent and looks like it's about, I don't know, 400 days it was plus 4 percent.
And then here, I can't even figure that out, something at plus five. After that,
they looked like you can't even see them anymore. So you might conclude by looking
at this histogram that stock market returns are always between say minus six
percent and plus six percent. A matter of fact, on October 30, 1929 the stock
market went up 12.53 percent in one day. And on October 19, 1987 the stock market
fell 20.47 percent in one day. It was quite a shock. By the way, on this day I was
lecturing giving my...this class I was teaching ECON 252, and one of the students
was listening to a transistor radio. Do you know what a transistor radio is? It's
what they used to have before you had iPhones and things like that. So he raises
his hand, I will never forget this, and he said, "Did you know the stock market is
crashing right while you're giving this lecture?". So, instead of going back to my
office, I just thought, "What is he saying?" I went downtown and I talked to my
stockbroker, Merrill Lynch, right here in New Highland. I took the elevator up and
just walked in on there just to see what was happening. And it was this turmoil and
everyone, I did manage because I walked in. If you tried to call your broker, you
couldn't. He wouldn't answer, he's too many calls but I walked in, barged in on him
and I said, "What's happening?" And he said, "Don't worry, don't panic. There was
this big event, horrible event.". That was the biggest drop, one day drop, ever in
the whole history of the U.S. stock market so I had the good fortune to be warned
of it by my student with the transistor radio. The fact that my student, this is
before laptops, but he did...we had problems with transistor radios back then. So
that's an outlier. The normal distribution with the same mean and standard
deviation as this histogram says that the probability of a drop greater than 20
percent is equal to 3*10^-71. That's awfully close to zero if you know. I think
that the estimated number of atoms in the universe is bigger, that's 10^80 but it's
getting on like that. So, it's essentially zero but it's wrong because it happened
and I was there. I saw it happen and I saw the excitement that it generated.