A great analogy that will provide insights with portfolio construction is to think about the Joseph and Noah effects. The "Joseph effect" is the simple idea that there is long-term persistence. As stated in Genesis, seven good years may be followed by seven bad years in Egypt. Overall, the world is a stable and the past can tell us something about the future. That may be a good working assumption, but the world may also see the "Noah effect". Financial markets may be stable, but every once in a while, there will be the great flood of a crash and everything will be washed away. We don't know when the great flood will come, but we need to be prepared for these tail events.
Portfolios structured for the Joseph effect may go a very long time without a problem, but then the flood of a major downside shock will come. However, thinking that the 100-year flood is coming every year is not helpful. A portfolio will miss opportunities. There needs to be balance between building with normal tools but also looking at extreme value and expected tail loss statistics to track what is possible, albeit not likely.
Investors should go through the exercise of thinking about Joseph and Noah effects and whether they are prepared for both.
See "Noah, Joseph and Operational Hydrology" in Water Resources Research, 1968 for the original work on the Joseph and Noah effect as well as a discussion on the use of the Hurst range or statistic.
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