Why tail risk matters more than most people think

Most days, markets move only a little. But once in a while, they fall far more than anyone expects. That rare, extreme danger is called tail risk. This page explains what it is, why it happens more often than simple models suggest and how investors prepare for it.

Quick answer

Tail risk is the risk of a rare event that causes an extreme price move, far beyond normal daily changes. The name comes from the 'tails' at the ends of a bell-shaped curve of returns. Real market returns have 'fat tails', which means extreme falls happen more often than a normal curve predicts. Crashes like October 1987 and March 2020 are examples.

Key takeaways

• Tail risk is the risk of rare but extreme moves.
• Market returns have fat tails, so extremes are more common than expected.
• Black Monday in 1987 and the March 2020 crash are examples.
• VaR often understates tail risk.
• Diversification, cash and hedges can help manage it.

What is tail risk?

If you plot daily returns on a chart, most fall near the middle, with small gains or losses. Fewer days sit at the far left and far right, the 'tails'. The left tail holds the big losses. This is about the chance and size of those losses.

A normal bell curve suggests very large moves should almost never happen. But real markets show them more often. This feature is called 'fat tails', and it is why extreme events surprise so many investors.

Real examples of tail events

In March 2020, Indian markets hit their market-wide lower circuit breaker on more than one day, halting trading for a time. Such events are rare, but when they happen, the losses can be very large in a short time.

Why do standard risk tools miss it?

Many risk measures, such as basic value at risk, are built on normal market data and focus on typical days. They can understate how bad the worst days might be.

Measures like expected shortfall and stress tests try to look deeper into the tail. Writer Nassim Nicholas Taleb made the idea of rare, high-impact 'black swan' events widely known through his 2007 book.

How investors prepare for tail risk

Diversification across asset classes, such as shares, bonds and gold, can soften the blow, though different assets can fall together in a crisis. Keeping an emergency fund in cash means you are not forced to sell at the worst time.

Some investors buy protective put options as insurance against a sharp fall. These cost money, and the cost reduces returns in normal times. Avoiding too much leverage is also important, since borrowed money turns a big fall into a much bigger loss.

The key point to remember

Tail risk is the danger hiding at the edges of normal market behaviour. You cannot predict when it will strike, but planning for it can help you stay invested and avoid panic when it does.

The securities and commodities named here are mentioned only to explain how the market works and are not a recommendation to buy, sell or hold them.

Frequently Asked Questions