Tail risk occurs when an investment moves more than three standard deviations from its mean, potentially resulting in higher returns or losses. Monitoring and evaluating tail risk is important for investors to protect their portfolio and achieve investment objectives.
A tail risk is a type of risk that occurs when a particular investment within the portfolio exhibits the potential to move more than three standard deviations from the established mean for that security. The movement can be positive or negative, increasing the chances that the security will increase in value more than anticipated, or result in a loss that is beyond average. Assessing the degree of deviation and the amount of tail risk involved is common when looking at hedge fund returns.
The key to evaluating a tail risk is understanding what is meant by the mean and standard deviation. The mean is simply the normal or expected value of the asset. Identifying the mean allows one to determine what type of price action can reasonably be expected from the security’s movement, given market conditions as they exist today. The standard deviation is a measure of the security’s volatility, usually based on the past performance of that particular security. For securities that have a history of being somewhat stable, the deviation is considered low, while a security that has a history of significant up and down movement would have a high standard deviation.
Assessing tail risk is useful to investors, especially if there is a desire to limit the degree of risk involved with the assets contained in a portfolio. As the available information indicates that the degree of standard deviation moves outside of an acceptable range, the volatility of the asset also increases. When this happens, the investor must determine if this wider-than-average deviation from the mean is likely to result in enough returns to make the security worth holding, or if it should be sold before the trend moves forward.
The risk of the tail can point towards higher returns or higher losses. Monitoring the degree of risk is essential if the investor wishes to protect the integrity of the portfolio and continue to make progress towards their defined investment objectives. After determining the mean, the investor must take into account other factors that could lead the security to perform in a manner similar to a historical pattern, allowing for some possible divergences in market activity that will have a direct impact on the performance of the security. asset. . Evaluating tail risk allows you to identify the possibility of higher standard deviations, determine whether that higher deviation may result in a profit or loss, and then choose the course of action that you consider most appropriate.
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