Tail Risk, Fat Tails, and What They Mean for Investors
Tail risk is the danger of large investment gains or losses because of sudden and unforeseen events. The term “tail risk” refers to the tails on a bell curve: While the fat middle of the bell curve represents the most probable returns, the tails — both positive and negative — represents the least likely outcomes.
When looking at the bell curve that gives the phenomenon its name, investors sometimes also refer to tail risk as “left-tail risk,” as it refers to the very unlikely and very negative outcomes on the curve.
What Is Tail Risk?
Tail risk is defined by a concept called standard deviation. As a metric, standard deviation shows how widely the price of an asset fluctuates above and below its average. For a volatile stock, the standard deviation will be high, while the standard deviation for a stock with a steady value will be low.
Standard deviation is an important number that investors use to understand how historically volatile a stock is, as well as the level of volatility they can project for it in the future. That projection is based on the underlying assumption that the price changes of a stock will follow the pattern of what’s called normal distribution.
Normal distribution is a statistical term used to describe the probability of an event, and it shapes the bell curve. If you flip a coin 10,000 times, how often will it land on heads or tails? Each time, there is a 50% probability it will land on heads or tails, and the curve describes the likelihood that those 10,000 flips will come out 50/50. The fat middle of the curve says it will be close to 50/50, but there are extremely low probabilities at the low (or skinny) ends of the bell curve that it could be more like 80/20 heads or 80/20 tails.
That approach to probability predicts that a stock selling at a mean price of $45 with a $5 standard deviation is 95% certain to sell between $35 and $55 at the close of that day’s market.
“Tail risk” is used to describe the risk that an investment will fall or rise by more than three standard deviations from its mean price. To continue the example, the hypothetical stock $45 stock has entered the domain of tail risk if, at the end of the trading day, it is priced at $30 or below, or at $60 or above.
💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.
What are Fat Tail Risks?
Unpredictable events are ironically predictable, and happen in the markets on a regular basis. And those markets, such as the one following the onset of the pandemic in early 2020, exhibit much “fatter” tails. Another period characterized by having an extremely fat tail was the 2008 Financial Crisis.
They’re called “fat tails” because the outcomes that had been on the extremes were suddenly happening, instead of the ones previously considered probable. This condition is also called by the mathematical term leptokurtosis. As a general rule, because they deviate so wildly from the expected norm, fat tail events present great risk as well as great opportunities for investors.
Tail Risk Strategy
Financial models such as Harry Markowitz’s modern portfolio theory (MPT) or the Black-Scholes Merton option pricing model, employ the assumption that the returns of a given asset will remain between the mean and three standard deviations.
The assumptions made in these long-term market projections can help with planning. But they’re not realistic about how investors receive their market returns over the long term. Rather, the bulk of their returns, no matter how diversified their portfolio, are largely the result of positive tail events. The power of tail events over long periods is one reason that experts tell investors to stay in the markets during fat-tail periods of volatility, even if it is stressful at the time.
Why Investors Hedge Tail Risks
Left-tail events also have the potential to have an extremely negative impact on portfolios. That’s why many investors hedge their portfolios against these events — aiming to improve long-term results by reducing risk. But these strategies necessarily come with short-term costs.
Downside Protection
One strategy that’s designed to protect against tail risks involves taking short positions that counterbalance the rest of a portfolio, also known as buying downside protection. For example, if an investor is heavily invested in U.S. equities, they may consider investing in derivatives on the Chicago Board Options Exchange (CBOE) Volatility Index (VIX), which correlates to the inverse of the S&P 500 index. (Using short strategies is also one way to invest during a bear market.)
Another way to hedge by buying downside protection is to purchase out-of-the-money put options. When the assets connected to these put options go down, the put options become more valuable. Granted, buying those options costs money, but it can be a strategy to consider for investors who believe the markets are likely to be volatile for a while.
Tail Risk Parity
Tail risk parity is a way to structure a portfolio based on the expectations that events that have a negative impact on one asset class will likely be a boon to others. This requires looking at each asset class in terms of how it might fare in the event of a particular crisis, and then finding an asset class that would likely do well in that same circumstance, and then keeping them in balance within your portfolio.
Managed Futures Funds
Other investors who want to trim their exposure to tail risks may invest in managed futures funds. These funds buy long and short futures contracts in equity indexes, and can thrive during times of crisis in the markets.
The Takeaway
A tail risk is the risk that an event with a low likelihood of happening will happen. And it’s something that investors need to keep in mind. There are a few different ways to mitigate the impact of tail risk in an investment portfolio, but for long-term investors, it can be helpful to keep in mind that tail risk is responsible for most returns over time.
Tail risk and fat tails may seem like granular investing terms, but they do play a role in the markets, which means that every investor can benefit from learning about them, and how they can affect a portfolio.
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