Why “Tail Risk” Should Be in Your Investment Vocabulary

A tail risk is the probability of a rare event occurring.  The tail is the left and right portion of a normal distribution curve which resembles a bell and therefore carries the name “bell curve.”

Author and investor Nassim Taleb explored the concept of tail risk in his 2007 best-seller The Black Swan: The Impact of the Highly Improbable. In the book Taleb tries to draw the reader’s attention to the idea that too often we are blind to randomness. As a result, we are exposed to the cataclysmic fallout from events that are possible, though improbable.

Investors across the world have experienced a rude awakening to this idea. As the COVID-19 pandemic continues to ravage economies, investors are discovering that they can in fact find themselves sliding down the bell curve into tail risk territory.

The “tail” however, is a strange place. When examined from the perspective of a diversified portfolio the tail represents both threats and opportunities. Consider that “gold tends to outperform in left-tail events,” according to research recently published by the World Gold Council. This outperformance does not always look like surging returns. Sometimes outperformance simply means being able to weather the storm and hold on to assets when others are watching their investments (equities and fixed-income) sink.

Others before Taleb have attempted to warn people of the unseen dangers lurking within the Byzantine systems we build. In his book Normal Accidents, author Charles Perrow argues that “we create systems—organizations, and the organization of organizations—that increase the risks for the operators, passengers, innocent bystanders, and for future generations.”

Academic Stephen H. Kellert touched on this idea when he coined the term, “predictive hopelessness” in his book In the Wake of Choas: Unpredictable Order in Dynamical Systems. Others, like Gerald Schueler who wrote The Unpredictability of Complex Systems, explains that “complex systems all have feedback mechanisms,” and that “tiny errors will creep into the feedback system.”

Today we are seeing that the accumulation of these errors can lead to an economic system that is unprepared for a pandemic. For those who hold gold as part of a diversified portfolio, however, these risks, while unavoidable, can be mitigated. Consider additional research from the World Gold Council report which finds that the correlation between gold and the stock market becomes more negative as equity market moves intensify. That is, as the S&P 500 experiences larger swings gold increasingly moves in an opposite direction. This fact has become especially evident in the last 8 weeks of market turmoil where the correlation between gold and the S&P 500 has reached much further into negative territory than the same correlation measured over the last 59 weeks.

When sweeping upheaval hits the equities market gold often seeks the high ground, helping investors to weather the storm. As authors like Taleb, Kellert, and Schueler issue warnings, many of us go about our lives without even a moment’s reflection on what awaits around the next corner. Gold, as an investment, reminds us that we can make at least some protective measures today.

 

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1 thought on “Why “Tail Risk” Should Be in Your Investment Vocabulary

  1. Looking forward to the weekly reports Thanks

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