Definition of tail risk

Tails are the end portions of distribution curves represented by bell-shaped graphs that show the statistical probability of a measured event. The tails on the left and right of the bell shape represent the least likely outcomes. In investment terms bell curves can be used to plot investment outcomes. The lowest returns are represented on the left and the highest on the right.

However, tails can be fatter than the normal distribution curve.

A long term investor will want to minimise left tail risk without losing out on right tail growth potential.

Investors can attempt to minimise tail risk (the risk of a fat tail) by tail risk hedging. They can limit the risk in their asset allocation by choosing sectors that are likely to be less volatile, or complement their long term strategy with derivative positions, for example.

See below for a Pimco diagram illustrating tail risk to investors.

In March 2013 a special report on risk management in the FT looked at how hedge fund managers were coping with the additional risk of growing from one man bands into miniature institutions. Hedge funds' main task of providing insurance against tail risk could be complicated by having multiple teams of traders. It could mean that the same firm may actually be taking the same risk many times over.