Fat Tails, Tail Risk

 

Found this on Linked In and deserves  special attention

 

What is ” Tail Risk ” (FAT TAILS) ? 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.

The concept of tail risk suggests that the distribution of returns is not normal, but skewed, and has fatter tails.

The fat tails indicate that there is a probability, which may be small, that an investment will move beyond three standard deviations.

Kurtosis is a statistical measure that indicates whether observed data follow a heavy or light tailed distribution in relation to the normal distribution.

The normal distribution curve has a kurtosis equal to three and, therefore, if a security follows a distribution with kurtosis greater than three, it is said to have fat tails.

Distributions that are characterized by fat tails are often seen when looking at hedge fund returns. Hedging against tail risk aims to enhance returns over the long-term, but investors must assume short-term costs.

 

Brian Twomey  Contact brian@btwomey.com

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