Tail risks refer to the probability that the price of an investment asset moves above three deviations away from the current price. Tail risks are difficult to predict and symbolic of rare events that fall at the far ends, or tails, of the probability distribution curve in finance and investing. They are at the far edges of the normal distribution curve, indicating that tail risks have a low probability but significant implications for an investment portfolio.
Understanding Tail Risk
Tail risks refer to the tails of a bell curve when looking at the normal distribution of an investment asset. While tail risks can occur on the right side and left side of the bell curve, the left tail risk is the one concerning your investment portfolio. A tail risk that causes a price drop above three standard deviations from the mean can cause significant losses, damaging or even destroying an investment portfolio.
Black Swan Events and Tail Risks
Black swan events are rare events that cause tail risks. They are unpredictable occurrences, such as a natural disaster, geopolitical event, or pandemic, that have a sudden and significant effect on market returns. Real-world examples of black swan events that created tail risk realities include the 2008 housing crisis, the COVID-19 pandemic, and Black Monday of 1987.
Tail Risks and the Normal Distribution Curve
The normal distribution in statistics or finance is usually symmetrical and characterized by a bell-shaped curve. The data points remain generally closest to the mean and taper equally toward the right and left. Under normal distribution, approximately 68% of the data falls within one standard deviation from the mean, 95% within two standard deviations, and 99.7% within three standard deviations. Everything beyond the third standard deviation is considered a tail risk. This distribution assumes that extreme events (tail risks) are rare, with the probabilities of outcomes decreasing exponentially as they move further from the mean. However, real-world financial data often exhibit “fat tails,” indicating that extreme events occur more frequently than the normal distribution would predict. Understanding the limitations of the normal distribution is crucial for accurately assessing and managing risk in investments.
Fat Tails
Fat tails indicate that tail risks or black swan events are more likely to occur than the normal distribution portrays. Traditional risk management techniques often underestimate the likelihood and impact of these extreme events when considering your investments, leading to a false sense of security. Fat tails indicate that severe market downturns, financial crises, and other extraordinary events occur with greater frequency and intensity than expected. As a result, it is important to adopt more robust risk management strategies that account for these fat tails that could lead to significant losses.
Measuring Tail Risks
You can measure tail risks by identifying and quantifying the potential for extreme losses. Analysts commonly use these three methods to measure tail risk in an investment portfolio.
| Method | Description |
| Value at Risk (VaR) | Estimates the maximum potential loss of a portfolio over a specific time frame under normal conditions. |
| Conditional Value at Risk (CvaR) | Estimates expected losses beyond the VaR threshold, providing a more comprehensive view of tail risks. |
| Stress Testing and Scenario Analysis | Simulates extreme market conditions to assess portfolio performance and reveal vulnerabilities. |
Tail Risk Hedging
It is important to use risk hedging strategies to safeguard investment portfolios from the adverse effects of tail risks. Investing in gold is one way to create diversification in your portfolio that might survive tail risks.
- Diversify your portfolio to spread risk.
- Invest in high-quality assets with strong fundamentals and resilience to economic downturns.
- Keep a portion of your portfolio in liquid assets, such as gold bullion, cash or short-term bonds.
- Regularly review your portfolio and adjust it as needed.
Using strategies to protect your investments can help you navigate wild swings in the market and preserve your wealth. Always remember tail risks, as destroying a portfolio that isn’t created with their possibility in mind only takes one.
Using Gold to Hedge Tail Risks
Another way to protect yourself against tail risks and black swan events is by incorporating gold into your investment portfolio. Gold is a safe-haven asset that has maintained its value over thousands of years and usually reacts in the opposite direction as the stock market. It has consistently held the same buying power over the years, exemplified by its ability to consistently buy a nice men’s suit over decades and even centuries. Throughout history, gold’s intrinsic value, finite supply, and historical performance have made it popular amongst investors who want to mitigate risk and have sound money. Including gold in your portfolio diversifies your assets and provides a buffer against the impacts of tail risks, helping to preserve your wealth in unpredictable markets.
