Understanding Tail Risk And Its Wealth Management Implications

In the world of wealth management planning services, the issue of risk looms large. A specific form of risk, commonly referred to as tail risk, is one of the trickier issues even for the smartest professionals to wrap their heads around. It's a simple concept that isn't always self-evident in wealth management planning until something massive and unexpected hits. Let's explore what tail risk is and how planners try to prepare for it and even take advantage of it.

Defining Tail Risk

Picture what in math is known as a normal distribution. The classic example of a normal distribution is a bell curve, although there are some others.

At the far ends of the graph are two so-called tails. There's a flat part in the middle that represents most of what happens in the world on a given day.

For example, you might tally how many days the stock market returned percentages of one, a negative one, two, negative two, and so on. The vast majority of days would be boring stuff in the middle, hovering largely to one side or the other of zero, but with a slight skew toward the positive side.

At the tails, however, there would be a handful of days where the market returned or lost huge percentages, such as negative 10%. That fast and brutal haircut that few saw coming is tail risk.

Tail Risks Everywhere

Virtually all wealth management planning will run into tail risks, and it's important to have your financial portfolio configured to handle them. In fact, hedge fund managers often plan around tail risks that others are mispricing with the goal of cleaning up when all hell breaks loose. You'll see tail risks driven by wars, supply disruptions, political changes, and even old-fashioned shifts in tastes.

What Do You Do About Tail Risks?

Insurance and financial hedges are the two biggest weapons against tail risk. Folks who buy life insurance, presuming they have paid fair prices and carry enough coverage, are preparing for a specific tail risk their family might face if they were to unexpectedly die.

Planners often use the options market to buy insurance against seemingly uninsurable things. If you have an investment portfolio that's heavy on the energy sector, for example, you might purchase put options as hedges against the possibility the price of oil will crash to an unacceptably low number.

Diversification is another good tool. By spreading your wealth into different asset classes, you can reduce the risk that the unexpected collapse of one sector will wipe your finances out.