Tail risk definition

An event with a very low probability of occurrence, which could have a substantial consequence for portfolios and financial markets.

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A tail risk event occurs when the investment value fluctuates away from its mean by more than three standard deviations – Photo: Shutterstock
                                

In financial markets, it is assumed that the returns generated from different securities and portfolios have a normal distribution – also called a bell-shaped distribution. An event can trigger the tail risk at either side of the normal distribution or bell, ie, the tails.

The left side of the normal distribution points to the lowest-possible returns on investment, while the right side indicates the highest returns. Depending on the side, there could be a left tail risk or right tail risk. Left tail risk takes place on the left side of the bell, and it shows the negative returns of a portfolio. Right tail risk is dealing with the positive returns which could be generated.

Tail risk meaning

A tail risk event occurs when the investment value fluctuates away from its mean by more than three standard deviations. The probability of such an event is very low, but there could be drastic negative consequences for portfolios and for financial markets. Tail risk events are arguably responsible for increased market volatility. Losses arising from a tail risk event are much higher than the anticipated fall in asset prices.

How to protect your portfolio

Investors can protect themselves by holding assets that increase in value as financial markets move downwards. They can also use a tail risk hedging strategy. This means dedicating a portion of their return to buy some form of protection against unexpected significant loss.

Further reading

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