Kurtosis tells us where the risk exists. On a monthto- month basis, does the investment typically display a moderate amount of risk? Or does the investment appear to have little risk until the risk suddenly hits all at once? Kurtosis tells us whether the risk is spread evenly through the distribution of returns or if it tends to be concentrated in tail events.
Generally speaking, one would hope to see a low or negative kurtosis. A low or negative kurtosis means that on a period-by-period basis most observations fall within a predictable band. The risk that does occur happens within a moderate range, and there is little risk in the tails. Alternatively, the higher the kurtosis, the more it indicates that the overall risk of an investment is driven by a few extreme “surprises” in the tails of the distribution.
Kurtosis as a stand-alone metric is not very useful. Kurtosis is only useful when used in conjunction with standard deviation. It is possible that an investment might have a high kurtosis (bad) but the overall standard deviation is low (good). Conversely, one might see an investment with a low kurtosis (good) but the overall standard deviation is high (bad). Kurtosis gives a better understanding of standard deviation, but used in isolation kurtosis is meaningless.
The distribution for US Large Cap Stocks is in blue, while High Yield Bonds are in red. The shapes of the two distributions are quite different. Large cap stocks exhibit higher overall risk, as evidenced by the wider range of the distribution. This distribution resembles the classic, bell-shaped curve. While there is more risk overall, the risk is not concentrated in any section of the curve.
The distribution for High Yield Bonds is quite different. Most of the returns are clustered towards the center. However, on rare occasions High Yield Bonds exhibit extreme gains or losses, and this is what is meant by high kurtosis. It is the statistical equivalent of the old saying, “when it rains, it pours.”
A normal distribution would have a kurtosis of 0.0. Investment grade fixed income has kurtosis values closest to 0.0, meaning the return distributions are closest to fitting a normal, bell-shaped curve. High yield bonds have higher kurtosis values, even though their standard deviations tend to be lower than the equity asset classes. The interpretation for high yield bonds is that while the overall risk is lower, when the risk does happen it tends to be extreme.
Kurtosis is also known as the fourth moment of the distribution, used in conjunction with mean, standard deviation, and skewness to understand the shape of a distribution of returns. In its base case, kurtosis has a neutral value of 3.0. The calculation is frequently modified by the second term in the equation below, which scales kurtosis so that the baseline, neutral value is 0.0.
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