Tail Risk

  • April 25, 2017
Mike Jones tail risk

Mike Jones

Investment Insights

Mike Jones

The white paper A Comparison of Tail Risk Protection Strategies in the U.S. Market was tailor-made for the investment advisor who takes risk seriously. While written for those in the investment industry, its findings are very relevant for all.

As the global financial crisis of 2007-08 was remarkable in its severity, one of the most powerful lessons learned was that of correlation. During this particular crisis almost all asset classes declined in value. It seems as though there was no protection from having a diversified portfolio.

To illustrate this notice in the charts* below how the correlation of varying assets get closer (not farther) during a crisis. How sad is this? Just when you need diversification the most it fails you.

tail risk

*Note: [The writers] defined a normal state as any month when the S&P 500 returned greater (more positive) than -5%, and a crisis state as any month when the S&P 500 fell -5% or worse. There were 261 total months in this test. Of those months, 234 were normal and 27 were crisis months. The left panel shows asset correlations for the normal months versus the S&P 500, while the middle panel summarizes the correlations for the crisis months. The right panel simply shows the difference between a crisis state and a normal state correlation of each asset class versus the S&P 500.

Every investor knows that on any given day he is subjected to risk in the marketplace. As diversification breaks down and returns go south, our industry has created a term to define this extreme but seldom experienced event. We affectionately call it “tail risk.” As one plots the distribution of returns overtime and forecasts expected returns in the future, it is the left tail of the distribution chart that represents such tail risk.

The white paper categorizes the four primary ways that investment firms have pioneered strategies to manage tail risk and quantifies the effectiveness of each strategy. In the simplest of terms these for strategies are: Investing in Volatility, Low Beta Investing, Trend Following (across the futures market), and Tactical Asset Allocation.

For most of my career I have tried to respect the fact that markets can go into retreat mode for a season. In fact, there have been 10 occasions since 1946 where the market has dropped more than 20% (that’s once about every 7 years):

tail risk

Source: Standard and Poor’s, Fact Set / Note: Past performance is not a guarantee of future results.

I share this information with you this month because it is precisely at this point in time that your investment manager needs to be thinking about risk and how to mitigate the effects of the next bear market.

As I look over the asset allocation and tail risk investing of most of my portfolios, I see that we employ three of the four most commonly used approaches mentioned already. Look closely and you will detect Trend Following, Tactical Asset Allocation, and Low Beta Investing in some measure.

As always, the goal is to maximize returns to the upside when they are present, knowing that we will sacrifice some profit for the complimentary goal of protecting principle when markets go south.

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Byron R. Moore, CFP® is Managing Director / Planning Group of Argent Advisors, Inc. Mike Jones is Managing Director / Investment Group of Argent Advisors, Inc. Write to either at 500 East Reynolds Drive, Ruston, LA 71270 or call (318) 251-5800. This newsletter is available via email on a free subscription basis. You can subscribe by clicking here. Direct any questions, comments or suggestions to Byron Moore at bmoore@argentadvisors.com or to Mike Jones at mjones@argentadvisors.com.
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