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Understanding Tail Risk and How to Protect Your Investments

Tail risk is the possibility of large investment losses due to sudden and unforeseen events. The name tail risk comes from the shape of the bell curve. Under normal circumstances, your investment will most likely be in the middle of the curve. For long-term investors, this would represent your average expected return. The more extreme returns are less likely to occur and will decrease towards the end of the curve.

Source: PIMCO

The tail on the far left represents the potential for unexpected loss. A far-flung substantial investment represents the most extreme results of profit. For long-term investors, the ideal portfolio strategy would try to minimize left-tail risk without limiting right-tail growth potential.

Why is tail risk important?

Intuitively, we all want to be on the ride side of the bell curve. We want to achieve above-average returns and sometimes “hit the jackpot” with big profits.

In real life, sudden economic, social and geopolitical events appear much more often than the rational human mind predicts. In addition, every three to five years there are significant market shocks that result in “fat” tails.

Also known as “Black Swans”, they are rare and unique. These “one-time” events put adverse pressure on your investment portfolio and create the risk for large losses. Tail risk events bring enormous amounts of financial and economic uncertainty and often create extreme turbulence in the stock market.

The COVID outbreak, Brexit, the European debt crisis, the collapse of Lehman Brothers, the Enron scandal, the collapse of the US housing market and the 9/11 terrorist attacks are examples of stock market shocks. Very few experts could have predicted them. More specifically, they brought about dramatic changes in our society and our economy, our consumer habits, and the way we do business.

Assessing Your Tail Risk Risk

Retired and close to retirement, people who need immediate liquidity, executives, and employees holding large amounts of corporate stock are more susceptible to risk events. If you fall into one of these categories, you need to review your level of risk tolerance.

Investment is risky. There really is no risk-free investment. There are only investments with different levels of risk. It is impossible to completely avoid risk. The challenge for you is to have a properly balanced approach to all the risks you face. Ignoring one risk that helps you prevent another doesn’t mean you’re in the clear.

winners and losers

It is important to remember that every blow to the system leads to a winner and a loser. For example, the COVID outbreak disproportionately affected leisure, travel, retail, energy and entertainment businesses. But it also benefited many tech companies as it accelerated digital transformation. As bad as it was, the global financial crisis plagued many large and small regional banks. But it also opened doors to a number of successful fintech companies such as Visa, Mastercard, PayPal and Square, and exchange-traded fund managers such as BlackRock and Vanguard. The stock market declined after 9/11, but so did defense and cybersecurity stocks.

Know your investment

Knowing your investments is the first step to managing your tail risk. This is especially important if you have concentrated positions in a specific industry, group of companies, or a single stock. Black swan events can affect different stocks, regions and countries differently. For example, the Brexit decision hurt the performance of most UK and European companies and had no long-term impact on the US economy.

Know your investment horizon

Investors with a longer investment horizon are more likely to face sudden losses. The stock market is looking ahead. It will absorb new information, hit and move on.

I always give this as an example. If you had invested $1,000 in the S&P 500 Index on January 1, 2008, just before the financial crisis, you would have doubled your money in 10 years. Unfortunately, if you were to need your investments in a year or two, you would be in big trouble. It took more than three years to fully recover your losses.

Diversity

Never put all your eggs in one basket. Diversification is the most effective way to protect yourself from unexpected losses. Diversification is the only free lunch you will ever get in investing. This allows you to spread your risk among different companies, sectors, asset classes and even countries, allowing your investment portfolio to survive tempering in various market conditions. A key aspect of diversification is that while you protect yourself from left tail risk, you also limit the right tail potential for outsized returns.

hold cash

Keeping cash reserves is another way to protect yourself from tail risk. You should have sufficient liquidity to meet your immediate and near-term spending needs. I regularly advise my clients to maintain an emergency fund equal to six to twelve months of your budget. Keep it in a safe place, but make sure you still earn some interest.

Remember what we said earlier. There is no risk-free investment – even cash. Cash is sensitive to inflation, For example, $100,000 in 2000 is only worth $66,800 in 2020. Therefore, having a boatload of cash will not guarantee your long-term financial security. You should find it earning returns higher than inflation.

In addition, cash has a huge opportunity cost tag. In other words, by holding large amounts of money, you run the risk of missing out on potential gains from choosing other options.

US Treasury

US government bonds have historically been a safe haven for investors during turbulent times. We have seen an uptick in demand for treasuries in times of extreme uncertainty and volatility. And conversely, investors leave them when they feel confident about the stock market. Depending on their maturity, U.S. Treasuries may pay you slightly higher interest than if you held cash in a savings account.

While offering the potential for few returns, Treasuries are still exposed to high inflation and opportunity cost risk. Also, government bonds are very sensitive to changes in interest rates. If interest rates rise, the value of your bond will decrease. On the other hand, when interest rates are lower, the value of your bond will decrease.

Sleep

Gold is another popular option for conservative investors. Like treasuries, the demand for gold increases during uncertain times. The trust for gold stems from its historical role as a currency and store of value. It has been a part of our economic and social life in many cultures for thousands of years.

As we moved away from the gold standard, the role of gold in the economy diminished over time. Nowadays, the price of gold is completely based on price and demand. A noteworthy fact is that gold performs well during periods of high inflation and political uncertainty.

In his 2011 letter to Berkshire Hathaway shareholders, Warren Buffett described gold as “an asset that will never produce anything, but is bought by the buyer in the hope that someone else … Will pay more for them in the futureā€¦..If you own an ounce of gold for eternity, you will still own an ounce of it at the end.”

Buying put options to hedge tail risk

Buying put options for major stock indices is an advanced strategy for hedging tail risk. In essence, an investor will enter into an options agreement for the right to sell a financial instrument at a specified price on a specific day in the future. Generally, this fixed price known as the strike price is below the current levels where the instrument is trading. For example, XYZ’s stock is currently trading at $100. I can buy a put option to sell that stock three months from now for $80. The option agreement would cost me $2. If the stock price of XYZ drops to $70, I can buy it for $70 and exercise my option to sell it for $80. By doing this I will immediately make a profit of $10. This is just an illustration. In real life, things can get more complicated.

The real value of buying a put option comes at a time of extreme overvaluation in the stock market. For the average investor, buying a put option to hedge risk can be expensive, time-consuming, and quite complicated. Most long-term investors will just weather the storm and profit from being patient.

last word

Managing your tail risk is not a one-size-fits-all strategy. The occurrences of black swarms are distinctive in nature, length and magnitude. Since each investor has specific personal and financial circumstances, left tail risk can affect them differently based on a variety of factors. For most long-term investors, the left tail and right tail events will offset each other in the long run. However, specific groups of investors need to pay close attention to their unique risk appetite and try to reduce it when possible.

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