Tail Risk
The probability of rare, extreme investment losses that occur at the far end of a return distribution.
What is Tail Risk?
Tail risk refers to the risk of an investment or portfolio suffering extreme losses that lie in the 'tails' of a probability distribution — events that are far from the average outcome and statistically unlikely, but not impossible. The left tail of a return distribution represents extreme negative outcomes; right-tail events are extreme positive outcomes. In risk management, tail risk focuses on the left tail — catastrophic drawdowns. Standard metrics like standard deviation and VaR at the 95th percentile leave 5% of outcomes in the tail unaccounted for. Better tail risk measures include Conditional Value at Risk (CVaR or Expected Shortfall) — the expected loss given that a loss exceeds the VaR threshold — and tail ratio (the ratio of 95th-percentile return to 5th-percentile return). Tail risks are amplified by leverage, illiquidity, correlated exposures, and fat-tailed return distributions. Tail risk hedging strategies include buying out-of-the-money put options, long volatility positions (VIX calls), and capital allocation to uncorrelated strategies.
Example
Nassim Taleb's 'tail risk fund' strategy systematically purchases deep out-of-the-money put options on equity indices. In normal years, the options expire worthless, producing small, steady losses. During the March 2020 COVID crash, when the S&P 500 fell 34% in a month, these puts generated enormous payoffs — transforming a portfolio catastrophe into a gain. The tail hedge earned outsized returns precisely because the tail event materialized.
Source: Investopedia — Tail Risk