What is Tail Risk? Can You Hedge It?
Tail risk is defined as the possibility that an investment can move more than three standard deviations from the mean in a normal distribution. Or in other words, it is the risk that everything that can go wrong, does go wrong. A recent example is the financial crisis of 2008, which resulted in extreme price changes in many investments from all asset classes.
I often get asked how we hedge our tail risk. The simple answer is, we don´t and the simple explanation is, that there is no free lunch. Put it this way, if you could hedge your most damaging risk and still make money, you would always win. Everybody would like to find that trade, which is also why it doesn’t exist. The seamless allocation of the immense amounts of capital in today’s efficient markets makes sure of that. But it also makes sense that if a risk-free trade were to exist, it is highly improbable that I would find it and, certainly even more unlikely, that someone who had found it, would have told me about it.
So, if you can’t hedge tail risk, what can you do? You can mitigate the effect by buying insurance. Like everything in life, you get what you pay for. It may sound obvious, but it bears iterating, in that to truly protect your asset(s), you need to buy insurance on the same underlying asset. In other words, if you want to protect an equity, you need to buy puts in the same equity and hence the same underlying risk. Because of this, the protection tends to be fairly priced and hence also expensive if you don’t get the timing right. Otherwise, you will keep paying premium after premium, until the very loss you sought to insure, may dwarf the compounding value of the premium you have bought. By way of example, if you were to spend 2% in put options every year this can compound to more than 50% in hedging costs over 20 years.
Then, there is the clever stuff: “well when the world is in trouble, everyone buys the US Dollar as their safe haven, and since currency volatility tends to be very low, it can provide cheap insurance.” Yup, until it doesn't. Ever heard of the crash we can all predict? Every crash is different, otherwise there wouldn’t be a crash. So, you could be spending all this smart premium on things that actually won’t protect you when things go horribly wrong.
Fact is, buying tail risk insurance is a timing strategy (which is notoriously difficult) and you will be better off spending that premium to diversify across assets that behave differently, so that when one part of your portfolio suffers, other parts prevail.