At one time oceanographers, contrary to ample anecdotal evidence, did not believe that rogue waves existed. Rogue waves are now known to be “..relatively large and spontaneous ocean surface waves that are a threat even to large ships and ocean liners.”
We touched on the topic of rogue waves three years ago as more precise measurements helped document their existence. We even went so far as to draw upon the parallels between rogue waves and seemingly sudden and large movements in the stock market. To quote ourselves at some length:
Just as anyone who ventures into deep sea waters takes the risk of rogue waves, so do investors who choose to invest in risky assets. Once one ventures beyond the safety and security of Treasury bills inherent risks remain. While regrettable this is in fact the only way investors can generate real returns in excess of inflation and taxes. Clearly some asset classes and markets are more prone to crashes and panics. However no market is immune. Like the sea there is no absolute protection against a crash. One can try and make one’s portfolio more “seaworthy” but that is by no means a guarantee of safety.
Now it seems that researchers are finding evidence that rogue waves are more common than earlier believed. Researchers using more refined techniques have demonstrated that out of seemingly random wave behavior potential rogue waves pop up more frequently than predicted by current models. From The Economist article on the subject:
Dr Heller says the results tend to support anecdotal evidence from seamen that rogue waves are not as rare as once thought.
Again the parallels with the stock market are evident. The last few years has demonstrated that equity market returns have distributions with fatter tails than those found in finance textbooks. In short, large moves the stock market are more common than those expected in a lognormal distribution.
The stock market of late has been on a tear of late, making it much easier to forget the market volatility we have faced in the past year and a half. If you believe that large market moves are more likely than theory would dictate then it should be reflected in your portfolio management (and risk management) processes.
We took a stab at this topic earlier this year in the midst of the market meltdown. Many investors at the time were disappointed that their asset allocation models provided them little relief in the midst of the bear market. Our thoughts at the time were that investors needed to have a more dynamic approach to the markets in light of this higher volatility. As noted earlier taking to the seas involves seemingly random risks, not unlike the stock markets.