Tail Risk

What is 'Tail Risk'

Tail risk is a form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution.

BREAKING DOWN 'Tail Risk'

When a portfolio of investments is put together, it is assumed that the distribution of returns will follow a normal pattern. Under this assumption, the probability that returns will move between the mean and three standard deviations, either positive or negative, is 99.97%. This means that the probability of returns moving more than three standard deviations beyond the mean is 0.03%, or virtually nil. However, the concept of tail risk suggests that the distribution is not normal, but skewed, and has fatter tails. The fatter tails increase the probability that an investment will move beyond three standard deviations.

Distributions that are characterized by fat tails are often seen when looking at hedge fund returns.

RELATED TERMS
  1. Long Tail

    In business, long tail is a phrase coined by Chris Anderson, ...
  2. Standard Deviation

    1. A measure of the dispersion of a set of data from its mean. ...
  3. Leptokurtic

    A statistical distribution where the points along the X-axis ...
  4. Normal Distribution

    A probability distribution that plots all of its values in a ...
  5. Platykurtosis

    A statistical measure that indicates the level of peakedness ...
  6. Empirical Rule

    A statistical rule stating that for a normal distribution, almost ...
Related Articles
  1. Forex Education

    Trading With Gaussian Models Of Statistics

    The entire study of statistics originated from Gauss and allowed us to understand markets, prices and probabilities, among other applications.
  2. Mutual Funds & ETFs

    Standard Deviation & Value At Risk

    Standard Deviation & Value At Risk
  3. Professionals

    Confidence Intervals

    CFA Level 1 - Common Probability Distributions - Confidence Intervals
  4. Investing Basics

    Using Normal Distribution Formula To Optimize Your Portfolio

    Normal or bell curve distribution can be used in portfolio theory to help portfolio managers maximize return and minimize risk.
  5. Investing

    Standard Deviation

    Learn about how standard deviation is applied to the annual rate of return of an investment to measure the its volatility.
  6. Professionals

    Distribution of Returns

    Distribution of Returns
  7. Mutual Funds & ETFs

    Standard Deviation

    Standard Deviation
  8. Fundamental Analysis

    Find The Right Fit With Probability Distributions

    Discover a few of the most popular probability distributions and how to calculate them.
  9. Fundamental Analysis

    Explaining the Empirical Rule

    The empirical rule provides a quick estimate of the spread of data in a normal statistical distribution.
  10. Term

    What's Skewness?

    Skewness describes how a data distribution leans.
RELATED FAQS
  1. How does a long tail become profitable?

    Understand what the long tail concept is and who pioneered it. Learn how a company using a long tail strategy becomes profitable. Read Answer >>
  2. What does standard deviation measure in a portfolio?

    Dig deeper into the investment uses of, and mathematical principles behind, standard deviation as a measurement of portfolio ... Read Answer >>
  3. How is standard deviation used to determine risk?

    Understand the basics of calculation and interpretation of standard deviation and how it is used to measure risk in the investment ... Read Answer >>
  4. How is risk aversion measured in Modern Portfolio Theory (MPT)?

    Find out how risk aversion is measured in modern portfolio theory (MPT), how it is reflected in the market and how MPT treats ... Read Answer >>
  5. What is the difference between the expected return and the standard deviation of ...

    Learn about the expected return and standard deviation and the difference between the expected return and standard deviation ... Read Answer >>
  6. What is standard deviation used for in mutual funds?

    See how standard deviation is helpful in evaluating a mutual fund's performance. Use it in combination with other measurements ... Read Answer >>
Hot Definitions
  1. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  2. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  3. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  4. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  5. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
  6. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
Trading Center