Although tail risk cannot be eliminated, its impact can be somewhat mitigated by a robust diversification across assets, strategies, and the use of an asymmetric hedge.
However, financial markets are not perfect as they are largely shaped by unpredictable human behavior and an abundance of evidence suggests that the distribution of returns is in fact not normal, but skewed.
Observed tails are fatter than traditionally predicted, indicating a significantly higher probability that an investment will move beyond three standard deviations.
[5] This happens when a rare, unpredictable, and very important event occurs, resulting in significant fluctuations in the value of the stock.
Fat tails suggest that the likelihood of such events is in fact greater than the one predicted by traditional strategies, which subsequently tend to understate volatility and risk of the asset.
[7] The 2007–2008 financial crisis and the Great Recession, which had a dramatic material impact on investment portfolios, led to a significant increase in awareness of tail risks.
Active tail risk managers with an appropriate expertise, including practical experience applying macroeconomic forecasting and quantitative modeling techniques across asset markets, are needed to devise effective tail risk hedging strategies in the complex markets.