A tail risk is a type of risk that comes about when a particular investment within the portfolio exhibits the potential to move more than more than three standard deviations from the established mean for that security. The movement may be positive or negative, increasing the chances for the security increasing in value more than anticipated, or generating a loss that is beyond the mean. Assessing the degree of deviation, and the amount of tail risk involved, is common when looking at hedge fund returns.
Key to the assessment of a tail risk is understanding what is meant by the mean and the standard deviation. The mean is simply the normal or the expected value of the asset. Identifying the mean makes it possible to determine what type of price activity can reasonably be expected from the movement of the security, given the market conditions as they exist today. The standard deviation is a measurement of the volatility of the security, usually based on the past performance of that particular holding. For securities that have a history of being somewhat stable, the deviation is considered low, while a security that has a history of significant upward and downward movement would have a high standard deviation.
Assessing the tail risk is helpful to investors, especially if there is a desire to limit the degree of risk involved with the assets contained within a portfolio. As available information indicates that the degree of standard deviation moves out 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 it worthwhile to hold onto the security, or if it should be sold before the trend progresses.
Tail risk can point toward greater returns or to greater losses. Monitoring the degree of risk is essential if the investor wishes to protect the integrity of the portfolio and continue moving toward his or her defined investment goals. After determining the mean, the investor must account for other factors that could lead the security to perform in a manner that is similar to a historical pattern, allowing for some possible divergences in market activity that will have a direct impact on the performance of the asset. Assessing tail risk makes it possible to identify the possibility of higher standard deviations, determine if that higher deviation is likely to result in a profit or loss, then choose the course of action that is deemed most appropriate.