Tail Risk Matters
Tail risk is the chance of extremely large losses. Systematic tail risk is the chance of extremely large portfolio losses due to large declines in one or more major financial markets, especially equity markets. Recent advances in finance research are revealing the importance of tail risk in pricing assets and managing investment risk. In particular, investors need to consider the difference between the risks of a portfolio with respect to small market moves and large market moves. A portfolio comprised entirely of low volatility stocks might have a lot more tail risk than a balanced portfolio containing high volatility stocks and short-term Treasuries. The reason is that all of the so-called low volatility stocks might in fact experience very large declines in price, while short-term Treasuries would be most likely to rise in price.