A tail event risk rating gives an idea of how vulnerable a portfolio would be in the rare event of a market shock. The distribution of market returns is expected to be normally distributed with the bulk of returns in the middle of the bell curve and fewer returns on either of the tails. Though uncommon, as their name would suggest, left tail events do occur and can be reasonably expected to occur with a higher probability i.e., more often than what a normal distribution would suggest as our global markets, regulatory frameworks and geopolitical influences become increasingly complex.
For StratiFi advisors, this is the go-to rating to look at for clients that are looking to conserve their capital. It can be utilized to find appropriate portfolios for clients in retirement seeking principal protection or clients with concentrated positions that are looking for a conservative low-risk investment portfolio to reduce their overall balance sheet risk.
At StratiFi, we believe the problem plaguing most allocators is that they underestimate the frequency and magnitude of capital destruction that can accompany tail events. For clients seeking to protect their principal, it’s not the probability of the event but rather the severity of the event that matters. Further, their first line of defense against tail events continues to be traditional multi-asset class diversification.
This rating is computed by considering only tail events. A full date range is used (from 1990), using corresponding benchmarks for those symbols that do not go that far in time. We define a tail event as a fall equal to or worse than -10% within a 10 trading day window. For each of those events, we look at the movements of the individual holdings and compute the weighted move of the portfolio as a whole. This allows us to compare the portfolio relative to the market movement during these tail events. We further quantify this on a one to 10 scale by calculating a statistic very similar to the so-called z-score.
A portfolio will exhibit:
A low (good) rating if it moves a quarter or less of the market move during tail events
A high (bad) rating if it moves the same or more than the market moves during tail events
An average rating if it moves around half as much as the market moves during tail events
We constructed our Tail Risk Rating to glean insights into how a portfolio may react to extreme events. Scaled from 1 (best) to 10 (worst), it will inform you how your portfolio might survive these theoretically rare events. Addressing this risk is crucial because a 33% move down in a few weeks necessitates a subsequent 50% move up to recover- which can take years.
Tail events are inevitable and demand focused attention from all fiduciaries as they contemplate the stressed risks in their allocations. Everyone remembers the impact of market sell-offs in 2000 (Dot-Com bubble), 2008 (Financial crisis), and even August 2015 (China currency float).
Our PRISM™ risk analysis software uses a blend of risk tolerance questionnaires, historical market events, and current market signals to provide advisors with all the data they need to know their customers and plan accordingly. Contact us to find out how StratiFi can help your practice and clients monitor risk across all investment holdings regardless of market conditions.