Tail Risk: Understanding the Odds of Investment Losses
Masterworks What is Tail Risk?
Tail risk refers to the chance of portfolio losses caused by rare events, as shown by a normal distribution curve. It’s the risk of an investment’s returns being much lower than expected.
This is often caused by unexpected events with a low likelihood of occurrence but large impacts, such as natural disasters, financial crises or political instability.
Tail risk events can occur in any asset class. Typically, these events exceed investor expectations of frequency, duration and/or magnitude of losses.
What Are Tails?
“Tails” refer to the far end parts of normal distribution curves in statistics, represented as bell-shaped diagrams showing the probabilities of various outcomes. In investing, these curves depict the probability of obtaining different investment returns over a defined period.
In a normal bell curve, the most probable returns are concentrated in the center, or the average expected return. The more extreme returns are less likely and taper at the end as tails.
For long-term investors, the ideal portfolio strategy seeks to minimize left tail risk (the lowest returns) without curtailing right tail growth potential.
Understanding Tail Risk
Conventional portfolio strategies assume a normal distribution of market returns. However, tail risk theory posits that returns have a skewed, non-normal distribution with fatter tails.
This means there is a higher chance than expected of an investment experiencing a deviation beyond three standard deviations. This fatter-tail phenomenon is commonly observed in hedge fund returns.
Financial markets are impacted by unpredictable human behavior and don’t exhibit a normal return distribution. Fat tails, indicating a higher probability of returns moving beyond 3 standard deviations, are observed.
This can result in significant losses due to rare, unpredictable events referred to as black swans. These events can produce disastrous effects on portfolios in a short time frame. Fat tails suggest that traditional strategies tend to understate the risk and volatility of assets.
Fat Tails
Conventional portfolio strategies often rely on normal distributions to make market assumptions, but markets don’t behave in a predictable manner. Financial stress events happen more frequently and on a larger scale than many investors realize, with some estimates suggesting a significant market shock every 3-5 years over the past three decades.
These events create “fatter” tails than normal curves predict and quickly spread panic across markets, leading to declines across investments. These widespread and unpredictable events can significantly impact portfolio returns and potentially hinder investors from reaching their financial goals.
Measuring Tail Risk
Tail risk is quite difficult to measure because these events happen very infrequently and can have a variety of impacts. The most popular tail risk measures include conditional value-at-risk (CVaR) and value-at-risk (VaR).
These measures are used both in financial markets and in the insurance industry.
Normal Distributions and Asset Returns
When constructing a portfolio, it’s usually based on the assumption of normal distribution of returns.
This means that returns between the mean and +/-3 standard deviations have a probability of 99.7%. Returns beyond +/-3 standard deviations have a probability of 0.3%.
The normal distribution assumption is crucial to financial models such as modern portfolio theory by Harry Markowitz, which advocates for portfolio diversification for maximizing profit. However, this assumption doesn’t accurately reflect market returns, and tail events can have a big impact on returns.
Other Distributions
Stock market returns usually exhibit a normal distribution with higher kurtosis. Kurtosis is a metric that determines if a distribution is heavy-tailed (excess kurtosis) or light-tailed compared to the normal distribution (kurtosis=3).
A heavy-tailed distribution, or leptokurtic distribution, means extreme outcomes occur more frequently than expected. This results in a higher kurtosis than the normal distribution and securities following this distribution have returns exceeding +/-3 standard deviations from the mean more than 0.3% of the time.
Tail Risk Management Strategies
Rare negative tail events can cause significant negative returns, hence, investors looking to manage risk utilize a few common strategies.
Portfolio Diversification
Portfolio diversification is a strategy in which an investor spreads their portfolio across a variety of assets, industries and geographies, with the goal of reducing the impact of any one investment on their overall portfolio.
In the context of tail risk management, diversification could help reduce the impact of extreme events on an investment portfolio, since not all assets may be affected in the same way by such events. This strategy is improved if a portfolio includes assets with differing correlations, meaning their returns are not linked to the returns of other assets.
For example, Contemporary Art has offered negative or zero correlation with the equity market as well as other alternative assets, meaning those investment returns are not necessarily linked to overall market volatility that may impact equities, bonds and even real estate.
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By spreading investments across a diverse range of assets — especially non-correlated assets and alternative investments — an investor can reduce the impact of tail risk and potentially improve their overall average returns.
Hedging Strategies
The 2008 global financial crisis led to a heightened awareness of tail risk and an increase in investment strategy around hedging as risk management.
Hedging tail risk enhances long-term returns, though it comes with short-term costs such as purchasing derivative products or investing across asset classes.
To hedge against tail risk, investors can limit asset allocation risk by investing in less volatile sectors or complement their constant asset allocation with strategies such as equity put options, credit protection, currency, and interest rate options.
Derivative-based hedging strategies carry special risks, such as difficulty closing positions in certain market conditions, and the potential to lose more than the investment principal. To effectively implement these hedges, expert knowledge is crucial.
Therefore, many investors and financial advisors seek professional portfolio managers’ assistance to incorporate tail risk hedging into their investment plans.
The Bottom Line
Tail risk is a form of portfolio risk that refers to the likelihood of rare and extreme events that can significantly impact an investment portfolio.
It’s important to understand and assess tail risk, as it can potentially lead to large losses in a portfolio.
By implementing diversification and other common risk management strategies, investors can try to mitigate the impact of tail risk on their portfolios and ultimately, reach their investment goals.
The information in this article is provided for educational purposes only. This information should not be construed as investment advice and should not form the basis of an investment decision.
