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Myth #3: Tail Risks Are Rare

Tail Risks Are Rare

The investment year is divided into 252 days. On most days, investors know what will happen, but they don’t know how the financial markets will respond. A variety of analytical methods help anticipate how stocks will react to earnings reports and economic data, but ultimately everyone is exposed to the market’s known unknowns and unknown unknowns. The challenge is balancing that which we know will happen, even if we don’t know the outcome (known unknown), with those events that are impossible to predict (unknown unknowns).

Now, let’s pull back from this discussion and think of life as a bell curve. As almost everyone will agree, save for the unluckiest or most cursed amongst us, that most people’s experiences fall into the center of the bell curve. In that middle section, exists everyday life, and all of the ensuing joys and sorrows are often balanced. Outside of that central band, however, is extreme joy and extreme sorrow. Think of the birth and death of loved ones, illnesses, or anything else in your life that stands as major moments.

Now, let’s switch back to the investing world. The goal of all investors should be keeping their returns centered in the middle of the bell curve while insuring that the left tail (think anything unexpected that shocks and hurts investors) is kept from destroying the gulf stream of returns that increase the value of an investment portfolio. Unlike life, in which your decisions often lead to desired outcomes, financial markets expose all participants to many forces that are beyond their control and often beyond their comprehension. The question thus becomes how to maintain some mastery of a situation that is as emotionally stable, and predictable, as a teenager experiencing puberty.

If you believe, as many do, that barely anyone qualifies as a long-term investor because they usually greed in, and panic out, of the markets are precisely the wrong time, it makes sense to think about risk management. Many institutional investors and this includes mutual fund managers, hedge fund managers, and many others who invest for a living, pursue strategies that curl the tails of the bell curve into a shape that keeps portfolios centered in the middle of the market’s gulf stream.

The left tail, of course, represents catastrophic risk. Think of the Great Financial Crisis, or terrorist attacks, that shock the markets into sharp declines. In short, the left tail, usually just discussed as tail risk, is the stuff of Black Swan events that are supposedly improbable, and yet happen anyway with devastating consequences.

The right tail, which lives in the shadow of the more fearsome and celebrated left tail, represents a market utopia of return with little risk. Many institutional investors use the Shangri La of “right tails” to fund tail-risk strategies. They are willing to give up some of the glorious upsides to contain the risk that Black Swans, market disruptions, or various other events that are injurious to financial wellbeing, will damage their portfolio. This approach is also in acknowledgment of the cycles that influence the stock market.

Every five years, a bull market is born, dies, and is born again. The Global Financial Crisis has impacted the length of the historical market cycle because of extraordinary monetary policies that central banks used to save the world economy from collapse. Unusually low-interest rates encouraged many investors to shoulder all sorts of financial risk because of the “Federal Reserve Put.” The expectation that the Fed would not allow markets to tumble enshrined the “buy the dip” strategy, an approach that may finally encounter some resistance, and roiled the traditional definition of a market cycle.

As the Federal Reserve tries to normalize post-crisis monetary policy, the markets will likely return to their normal patterns. Indeed, concerns are high that the abandonment of easy-money policies may increase investment risks as investors react to changed realities and perhaps lose their appetite for viewing every market decline as an opportunity to buy stock.

To be sure, forecasting markets with a high degree of accuracy is nearly impossible. But it is possible to accurately define and monitor the risks that are embedded in portfolios. By measuring “tail risk,” advisors can help their clients better understand what to do, or how to respond before something bad happens. By defining outcomes, and discussing them with clients, advisors can help address some of the behavioral foibles that lead to bad investment decisions. This will help many individual investors become real, long-term investors who are not panicked by major shifts. In short, it will help them to learn how to let time work for them, and not against them.

StratiFi’s PRISM Ratings™ risk scoring technology provides RIAs, asset managers and broker-dealers more insight into the risks in their clients’​portfolios and their own business, so they can pick the risks they want to take. Contact the StratiFi team to find out more and get started today!

Akhil Lodha Author
Co-founder & CEO StratiFi Technologies

Building the industry standard for understanding portfolio risk through cutting- edge technology at Stratifi.

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