Tail risk

What is a tail risk? 

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. 

The following are the disadvantages of tail risk: 

• Investors might end up investing too much money to create a cushion that will help them to cover the loss.
• The tail risk events might not even take place at all as there is a very low possibility of that event taking place. 
• The tail risk could give rise to a sense of fear among investors, and they might stop investing in assets completely. 

How can investors save themselves from 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. 

What could be an ideal example of tail risk? 

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.