Tail Risk

Many financial models assume that returns follow a normal distribution, the familiar bell curve, where extreme outcomes are very rare. In reality, extreme market movements happen more often than this assumption suggests. Financial returns tend to have fat tails, meaning large losses and gains are more common than a normal distribution would predict.

Tail risk refers to the possibility of these extreme outcomes, especially severe losses. Examples include stock market crashes, such as in 1987 when the US stock market fell more than 20% in a single day, the 2008 financial crisis and the sudden market fall at the start of the COVID-19 pandemic in 2020.

For example, a portfolio that appears low-risk based on its normal day-to-day volatility might still suffer a devastating loss during a rare market crash.

Investors and institutions manage tail risk through diversification, avoiding excessive leverage, holding cash or safe assets, stress testing portfolios against extreme scenarios and sometimes buying protection, such as put options, which gain in value when markets fall sharply. Tail risk protection has a cost, which reduces returns in normal times.