Which is Worse: Heavy Tails or Volatility Clusters?

Heavy tails and volatility clusters are both stylized facts of financial returns that destabilize markets and are often neglected using the simplifying assumptions of normally distributed and iid returns respectively. This work disentangles the two sources and is the first to assess which one does the greater damage to financial stability and whether the threat can be reduced via diversification. As such, it also quantifies the potential shortfalls of the two commonly used simplifying assumptions. The analysis is carried out for index return series representing seven different asset classes and for individual stock portfolios. The stylized facts are isolated using recent developments in surrogate analysis (IAAFT, IAAWT). Our analysis shows that volatility clusters have a greater impact on maximum drawdowns and aggregate losses across all markets and that diversification does not yield any protection from those risks. In fact, diversification amplifies the translation of the two stylized facts into drawdowns, exacerbating their potential negative effects. We further demonstrate the practical relevance of our findings as we can replicate the results of our surrogate analysis using real portfolios. Moreover, we show that regulators should consider the impact of volatility clusters and discard the simplifying assumption of iid returns in order to enhance the accuracy of capital buffers.