Tail risk refers to the additional risk involved with an asset or portfolio of assets that arises due to the events with little probability of occurring. Tail risks are predicted by moving more than three standard deviations from its current price at both ends of a normal distribution curve. They are generally analysed tail risks before making any big or small investments in any hedging positions where the loss occurred could be compensated later.
The strategies that investors develop to prevent themselves suffering from tail loss due to such rare events loss are extremely beneficial during a financial crisis. Tail risk is an indicator of sudden loss and the indicator of overall investments and the company's future, whether it will sustain or not.
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The basic idea behind investing in assets is to gain future benefits from them. Therefore, we all aim to invest in profitable assets and are present at the right side of the bell curve. However, tail risk indicates the unpredictable and unavoidable circumstances that increase the risk of assets or portfolio of assets.
Even, in reality, we face many unpredictable events occurring in our lives that we hardly imagine would happen. The same thing can happen in the case of investing as well. Tail risk helps the investors to predict such situations and be ready to cover the losses.
Tail risks are also referred to as 'black swan' as they are rare and unique. However, these unpredictable events cause the maximum impact on the stock market and put immense pressure on an investor's portfolio. It might also give rise to a prolonged period of economic and financial imbalance.
For example, the COVID 19 outbreak can be considered one of such unpredictable events that have completely shaken up the world economy and caused an economic imbalance, which shall continue for a prolonged period. It is a wonderful example of tail risk wherein investors need to find strategies to overcome their losses caused due to the covid 19 pandemic.
It is assumed that the distribution of asset return will follow a normal distribution when the investment portfolio is put together. Therefore, investors assume that the probability of distribution of returns will lie between the mean and three standard deviations, either positive or negative, around 99.7%. This implies that the possibility of an asset return moving away from the three standard deviations is only 0.03%. This assumption related to the asset return works fine for several financial models, such as Harry Markowitz's modern portfolio theory (MPT) and the Black Scholes Merton optional pricing model. However, in reality, the tail risk is way more impactful towards the market returns than what is analysed from these predictions.
Tail risk comes with a bunch of advantages and disadvantages. Let us have a look at the advantages of tail risk first.
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The following are the disadvantages of tail risk:
Although 'black swan' or tail risk occurs due to events that are very rare but might have a heavy impact on the market returns, therefore, investors need to be ready for fighting such negative impact, or they must hedge against such events. Hedging against tail risk helps an investor to improve its goal towards long-term investment plans. However, it is essential to view tail risk from an individual perspective rather than a generalised point of view. For example, in the year 2008, whoever invested entirely in equities will remember the collapse of Lehman Brothers as a terrible disaster. On the other hand, the investors who had invested in Bunds were the best investments for them. Therefore, it can be rightly said that hedging strategies can never be a common one rather should vary depending upon the investment portfolio of every investor.
Let us consider the case of the Lehman brothers that took place in the year 2008. A company like Lehman brothers was said to be too big to fail. However, due to lenient policies and inaccurate reporting, the world witnessed the fall of this company which was unexpected.
The fall of Lehman impacted its shareholders or the banking sector and given rise to the collapse of several other sectors such as hospitality, steel, and construction, etc. Thus, the impact was felt and experienced by several other investors, and the entire world experienced an economic setback due to the collapse of the Lehman brothers.