What is tail risk?
Tail risk is the possibility that an investment included in a portfolio will shift more than three standard deviations from its current price. Standard deviation is a measure of how much an investment's returns can vary from its average return, so it shows how volatile an asset is.
Where have you heard about tail risk?
Broadly speaking, tail risk is something that’s very unlikely to happen, but still could. The probability that a return will change by three standard deviations is extremely low. It’s common for hedge funds to assess the degree of deviation and amount of tail risk involved.
What you need to know about tail risk.
Tails are represented on a bell-curve graph, which show the statistical probability of an event occurring. The tails on the left and right of the bell shape signify the least likely outcomes. You can use bell curves to plot investment outcomes.
Although tail events that impact negatively on portfolios are rare, there’s still a chance they could generate large negative returns. Therefore, you may want to hedge against these events. Hedging against tail risk means absorbing short-term costs to boost returns over the long-term.
Find out more about tail risk.
Read our definition of tail risk parity to learn about splitting risk across a portfolio.