There has been talk about “black swans” and tail risks for a number of years. What do these terms mean?
In the financial services industry, a black swan describes a very unlikely and severe event capable of sending shock waves through financial markets as a whole or specific asset classes. Due to its nature, such an event cannot be predicted. The bankruptcy of Lehman Brothers in September 2008 was an example. Within six weeks of the shock, the German stock market had fallen by 30 percent. With losses of that size, you will find yourself on the far left tail of the distribution of returns. That is where the term comes from.
How can you evaluate the impact of these events on a portfolio?
A black swan is, by definition, unforeseeable. True, there are scenario techniques that might be helpful in this context, but these remain incomprehensive. In the end, what matters to an investor, is the loss itself as opposed to the cause of the loss. That’s why the definition of tail risk does not necessarily include an unexpected or unknowable event but is rather linked to the existence of extraordinary or severe losses.
How can investors protect themselves against tail risks?
Tail risks can have a completely different impact depending on the individual situation: Those who were fully invested in equities in 2008 will recall the collapse of Lehman Brothers as a nightmare. In contrast, for investors in Bunds, the year was one of the best ever. To cut a long story short, tail risks have to be viewed and analysed individually from the respective portfolio. That means that there is no “one size fits all” solution for tail risk hedging.