Tail risk – do you need it?
There’s a lot of talk about tail risk these days. It came to prominence through Nassim Nicholas Taleb’s book The Black Swan. The crux of which being bad things happen more often than we expect.
Since the book, tail risk has started to enter the financial lexicon and more and more tail risk funds have started appearing, aimed mostly at sophisticated investors.
This article takes a look at what tail risk is and also asks whether or not you should invest in it?
What is tail risk?
Tail risk is something that could happen, but that has a low probability of happening. The phrase originates from the normal distribution of results, also known as the bell curve.
In other words a graph that looks like a bell with the base of the bell stretching out on both sides. These are the tails that represent the things that are unlikely to happen.
In other words, the top of the bell shows the most likely outcome and the further away you go from the top of the bell the more unlikely the outcome.
It could be something positive or something negative, but whatever it is, as the tails stretch out ever further the probability of it happening gets reduced.
The returns from investing pretty much follow along the same lines. In all likelihood A is going to happen, and if you are lucky B might happen, but at the same time if you are unlucky C might happen.
Basically, the returns from investing fit around a bell curve, normal returns in the middle, with the odd windfall and bankruptcy occurring around the edges.
The thing is, there’s a school of thought out there that thinks the bell curve in investing isn’t normal. Yes, the returns kind of fit around a bell curve, but with investing there’s one big difference. The tails on the investing bell curve are a lot fatter and that’s important!
So what?
Fatter tails basically means there is a greater probability of that certain something happening! Great, if it’s a good thing, not so great if it’s a bad thing. Because bad things mean losing money!
All these fancy statistical models the financial professionals use, at best, might not be quite as reliable as once thought, and at worse, might just be built on sand!
So where does that leave investors? Well, for the most part it leaves investors with the same conundrum they always had. A trade off between risk and return.
You need to take on risk to generate decent returns, but you need to avoid risk to avoid significant losses. The only difference is, you now have to take into account the fact that the losses may occur more often and be greater that was once thought.
If you want decent returns bite your lip, hold tight and take on risk, but be prepared for the fact that you may lose more money faster than you thought if things go belly up.
Alternatively, don’t take on any risk, but at the same time, don’t expect anything other than mediocre returns.
Have your cake and eat it!
But what if I told you there was another way? A way where you could have your cake and eat it! A way where you could invest with the promise of high rewards safe in the knowledge that you’d mitigated downside risk.
You’d probably be skeptical and rightly so. There aren’t many free lunches in life, and even fewer in investing.
But it turns out that there is something that lets you take on more risk, whilst offering more protection from market crashes. It’s called a tail risk strategy.
A tail risk strategy is like a traditional portfolio split between stocks and bonds but on steroids! Let me explain.
Most investors deal with risk and return, by splitting their portfolio between stocks and bonds, which equates to dividing between risk and non risk assets.
Stocks and bonds tend move up and down out of step with one another so that when the risky one, stocks goes down, the non risky one, bonds goes up and limits the losses.
Sounds great, but as with anything in life, it isn’t without problems. First and foremost, you need a lot of bonds to sufficiently mitigate the risk.
If bonds go up 10%, when stocks go down 50%, you aren’t going to do much mitigating if you don’t have a large portion of your portfolio in bonds.
Anything less than the traditional 60% stocks 40% bonds and you’d have been crying with the rest of them in 2008.
And this leads to a second problem, usually these bonds are a going to be a drag on the performance of your investment portfolio at other times, and these other times last a lot longer than the occasional bad time!
Having 40% of your portfolio dragging your investment returns down most of the time has got to be an issue for even the most risk adverse investors.
Strategies
And here’s where the tail risk strategy comes in. What if I told you there was a way to mitigate the bad times by allocating just a tiny sliver of your portfolio to safety, rather than the 40% or more bonds take up.
It works like this. Whereas bonds go up a bit when stocks go down a lot, a tail risk strategy goes up a heck of a lot when stocks go down.
This means you can allocate just a little bit of your portfolio to the tail risk strategy, leaving the bulk of it to stocks, meaning it won’t drag your portfolio down in the good times. You can see why some investors might just be interested in something like this.
There are various tail risk strategies out there. Some invest in volatility. Others in managed commodity futures. Then there are variance swaps, inflation floor agreements, tail risk protection indices, credit protection purchased in the CDS market, but the one I’ve come across most is out of the money put options.
Out of the money put options
A put option is an option contract that gives you the right to sell a specified amount of some underlying security at a specified price within a specified time frame.
Out of the money (OTM) means it has a strike price that is lower than the market price of the underlying security and the strike price is the price at which the contract can be bought and sold.
Tail risk funds often use these out of the money put options along side more traditional safe assets like gold and developed market government bonds.
Most people who want to invest in tail risk do it through funds, but there is the odd investor out there that takes a DIY approach to tail risk. But that’s going to require time and effort that most of us don’t have.
The way I see it, if you do it yourself, you’d need to spend your days combing the market searching for lots of micro bets with tremendous upside in the event of a black swan, but limited downside under normal conditions.
And to make it work, you’re probably going to need sophisticated maths ability, advanced software and lots of capital.
And most importantly, it’s going to require a great deal of discipline and conviction in your ideas from the start. Otherwise you won’t be able to handle that part of your investment portfolio losing money year after year after year after year……………. Because inevitably that is what will happen!
Could you really handle a portion of your investments constantly loosing money until that day of celebration when that catastrophic event finally hits the world?
At that time you’d be sitting pretty watching your investment portfolio surge, while everybody else’s plummet, but the time leading up to that point would be a painful experience for all but the bravest.
You’d have put in hours of hard work making trades that constantly lose money.
Yeah, your portfolio might be up overall, but knowing that it would have been up a heck of a lot more if you hadn’t bothered with tail risk would be a tough pill to swallow.
It’s a kind of situation where you feel good one year out of ten, whereas everybody else feels good for the remaining nine.
Professionals
Most investors aren’t going to be able to hand it, which leaves the tail risk fund option, leaving the experts to do the work.
But as with all instances where you hand over the rains to professionals in finance, your problems don’t necessarily disappear.
First and foremost you need to pay for it, and anything half decent isn’t likely to come cheap.
In essence a tail risk fund equates to a kind of insurance, and I can’t help thinking that the people who tend to profit from insurance are the ones selling it.
Just think about that for a moment. Paying big money for something that loses money year up on year. It definitely doesn’t sound too enticing to me!
Tail risk funds often say they are designed to lose money under normal conditions. And not insignificant amounts. I’m talking double digits annually here.
But then again, if it works when the big one hits, perhaps it’s worth it, and there in lies the second problem. How can you actually be sure it’s even going to work?
You can’t!
Will a tail risk fund even work?
Just because some fancy modeling and data mining says it’s going to work doesn’t make it so. Even if it’s a tried and tested method that worked in the past doesn’t mean it’s going to work in the future.
In finance things have a habit of working until they don’t. Nobody knows what the future holds, so it goes without saying that nobody knows what is going to bring the financial markets to their knees next time around.
Last time it was some complex derivative instruments that nobody really understood mixed with dodgy mortgages. Before that it was technology companies founded on fresh air.
The next once could be a repeat of one of those or it could be a rogue hedge fund like Long Term Capital Management back in 1998.
Right now, you wouldn’t be surprised to find that it had something to do with the ongoing trade war between the US and China. It may even be related to cryptocurrency.
But perhaps, more likely it will be set into motion by something totally unexpected. Something nobody saw coming.
After all, it’s easy to say there were clues after the fact, but these financial market collapses don’t tend to be easy to spot.
Yes you often see finance gurus on TV predicting this or that disaster, but if they really could predict these disasters you wouldn’t be seeing them on TV.
They’d be lying on their personal desert island washing caviar down with champagne, happy in the knowledge that they were one of the richest people on earth!
The bottom line
If you’ve got nothing better to do with your time, then feel free to take on the responsibility of tail risk yourself, combing the market, looking for those small bets, that will save you when the ship hits the fan.
If you find a tail risk fund that you believe in, that isn’t prohibitively expensive, then don’t let me stop you making an investment.
But for what it’s worth, I think people tend to talk about this stuff and think about investing in these kinds of products at just the wrong time. Namely after the event, or when they think a catastrophic event is coming.
And that’s more than likely going to be a time when you don’t need it, because if everyone thinks a big bad something is coming, it won’t be, because no-one knows when these kind of things come.
Worse still, when people thing something big is coming, these kind of products are going to be at their most expensive.
So for most investors, sticking with stocks and bonds and skipping tail risk is probably going to serve you better in the long run.
