25 standard deviation move

In an FT article today, Goldman talked about their fund that lost 30% last week. They claim it was as a result of not one, but several 25 standard deviation events in the market. In more common terms, that is a 1-in-100,000 YEAR event, and they had many of them! That is ridiculous, of course (After statements like that, it is amazing that the market isn't even lower). All of this comes about because this type of trading is driven by complicated computer models that some PhD quant guys developed in some windowless room in the basement of every bank, brokerage firm and hedge fund. The problem is three-fold. First, many of the models account for variables in similar ways, resulting in a herd mentality with everyone trying to put the same trade on at the same time (and trying to get out at the same time, hence the problem). This is the same problem with technical analysis, but at least with technical analysis there are generally clear signals to buy and sell (of course, everyone knows them). The second is that the people developing models generally have little experience in the financial markets, coming from fields like mathematics and physics, where human nature is not a variable. However, the most important is the inability to predict liquidity levels. Liquidity, in this case, means the ability to buy and sell. Like anyone in the real world knows, something is only worth what someone else is willing to pay for it, whether it is a used car, a house, the price of IBM stock, a mezzanine tranche mortgage security, etc. The models have a difficult time valuing that risk component (I have read some serious studies on the topic; most of it is nonsense). Fear has bounded back into the market and it is a good thing. For the past few years, fears went away as investors became more confident that nothing bad could happen and, even if it did, it could be accounted for and reduced/eliminated. This move is what should happen, and the market will be better off in the long-term (until the next time).

The last time I addressed this topic it was right after 9/11. I was working for a very large brokerage firm and they asked me to write a series of pieces on risk (if you a client of this firm, Smith Barney, you may able to view them on their website). Back then, corporate bond spreads had widened dramatically and they wanted me to explain it away, which I did. The one piece that got the most attention from our clients was the one on liquidity risk. They felt that we were using this piece as a justification for capitalizing on a bad situation. The reality is that liquidity risk is the "riskiest" risk of all for traders as there is no adequate method to reduce it. Interest rate risk, credit risk, etc. all pale in comparison. The good news is that the world isn't coming to end, only that value and common sense are returning to the market.