Tail Risk

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Tail risk is a form of portfolio risk that arises when the return on an investment move more than three standard deviations away from the mean; either to the lower or to the upper half of the return distribution.

Tail risks include events that have a small probability of occurring, and occur at both ends of a normal distribution curve. Even though tail risk lies on the both sides of the distribution; but investors are specially worry about tail risk on lower side of return distribution as lower side tail risk gives the probability of very high losses.

Understanding the Tail Risk: Traditional portfolio strategies typically follow the idea that market returns follow a normal distribution. However, the concept of tail risk suggests that the distribution of returns is not normal, but skewed, and has fatter tails. The fat tails indicate that there is a probability, which may be small, that an investment will move beyond three standard deviations.

Impact of Tail risk on the market: Tail risk is very difficult to quantify; as because tail risk occurs very rarely. Tail risk causes the correlation between securities to go up and consequently benefits of diversification goes down.

Protecting against the Tail Risk: One way to hedge against tail risk is by buying downside protection. Downside protections are strategies which give positive returns while market goes down. One of the very popular strategy is buying out of money put option; which results into positive returns while market goes down.

Key Takeaways:

  1. Tail risk is the chance of a loss occurring due to a rare event, as predicted by a probability distribution.
  2. Colloquially, a short-term move of more than three standard deviations is considered to instantiate tail risk.
  3. While tail risk technically refers to both the left and right tails, people are most concerned with losses (the left tail).
  4. Tail events have had experts questions the true probability distribution of returns for investable assets.

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