Tail Risk (Portfolio) - Explained
What is Tail Risk?
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Table of ContentsWhat is Tail Risk?How Does Tail Risk Work?Normal DistributionDistribution TailsHow Investors can Hedge against Tail RiskWhat are the Available Options for Investors?Recouping Losses Portfolio Protection Summary
What is Tail Risk?
Tail risk refers to a form of a portfolio risk where there is a possibility of an investment shifting beyond three standard deviations from its prevailing price. Tail risk measures the variance of investment returns from its average returns. The probability occurrence of tail risks is usually small, and happens at both ends of the bell curve normal distribution curve).
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How Does Tail Risk Work?
According to traditional portfolio strategies, market returns do follow a distribution that is normal. However, this is contrary to the tail risk concept which suggests that the returns distribution is skewed (not normal) and that it has fat tails. The fat tails here means that there is a small probability that an investment will move more than three standard deviations. Note that the distribution that has fat tails features can be seen when an investor is hedging fund returns. Generally, it is important to note that the impact of tail risk varies completely and it highly depends on the individual situation. This then means that tail risk hedging as an entity is not enough for investors to rely on when hedging risks across different portfolios. For this reason, it is important for the person investing to ensure that he or she looks at and carefully assesses the risks from a given portfolio.
There is an assumption that when investments portfolio is put together, then there will be a normal distribution when it comes to the distribution of returns. This means that the probability of returns moving between the mean and three standard deviations, be it negative or positive, is about 99.7%. Meaning that the probability that the returns will move more than three standard deviations passed the mean is 0.3%. When it comes to market returns, the assumption that it will follow a normal distribution is important to many financial models such as:
- Harry Markowitzs modern portfolio theory
- Black-Scholes Merton option pricing model
Under distribution tails, there is a tendency that stock market returns will follow a distribution that is normal which also has excess kurtosis. Kurtosis here refers to a statistical measure that shows whether the data that has been observed following a light or a heavy-tailed distribution as far as normal distribution is concerned. Note that a normal distribution curve usually has a kurtosis equal to three. Meaning that if security happens to follow a kurtosis whose distribution is greater than three, then it means it has a fat tail. Heavy tailed distribution or leptokurtic distribution portrays a situation where extreme outcomes have occurred beyond what is expected. This means that securities that have this kind of distribution do experience returns that surpass three standard deviations more than the 0.3% of the outcomes that have been observed.
How Investors can Hedge against Tail Risk
Although it is rare that the tail events will have a negative impact on the portfolios, they can have large negative returns. This means it is important that investors hedge against rail events. Note that investors hedge against tail risk so that they can enhance returns over the long term. In this case, diversity of portfolios is important for investors if they have to hedge against tail risk.
What are the Available Options for Investors?
Note that there are two options in which investors can use to hedge against tail risk. They are as follows:
This option involves investors sitting things down. This means that they recoup their losses after a few years. This option is suitable for those investors with a long investment plan and who also do not have to require a mark-to-mark reporting. However, the majority of investors are not willing to hold their position by disregarding mark-to-market losses as they believe that it is not a correct approach.
Portfolio protection is the second option, and it happens to be the best option which most investors prefer. Portfolio protection which is also known better risk management involves right design questions. This is best for investors who are looking forward to getting attractive returns, as well as protection against tail risks. Note that a portfolio can be protected in two ways:
- Using options-based strategy-Here the investor buys put options because they have the capacity to effectively cap assets respective classes.
- Risk management-This is also another way in which a portfolio can be protected. This method is implemented via asset dynamic allocation. This is where there is shifting between classes, by the use of futures, as well as creating a profile that is asymmetric. This also includes market upside participation and protection against extreme losses just like the options strategy.
One good thing about using this approach is that it happens to be flexible and cost-effective compared to the strategy options. Another advantage is that its protection is immediate especially in events such as 9/11. Note that for the investors to achieve adequate returns, they will be required to take more risk. This means that they will need to expose their risky assets like:
- Emerging securities
- Alternative asset
It is crucial for a person investing to apply a variety of risk management to ensure efficient and extra protection. This is because diversification of portfolio alone is not enough to prevent effects related to tail risk.
Generally, tail risk management is a rare situation meaning that the probability of it happening is very low. However, this does not mean that it cant happen. It is therefore important for investors to ensure that they hedge against this risk.