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3 reasons why "tail risk" investment pitches sound like tall tales

July 06, 2011

| Senior Financial Analyst, CFA

Hang on to your savings accounts - Wall Street has a new investment pitch for you.

This shouldn't come as a surprise. The investment community's marketing machine is nothing if not resourceful. So the mood of the country is stubbornly pessimistic? So people won't buy the usual get-rich-quick schemes? Then Wall Street won't fight the gloom-and-doom, they'll find ways to exploit it.

An up-to-date example of this is selling investments that guard against something called "tail risk."

What is tail risk?

Tail risk is the possibility of something catastrophic happening, even if there is only a small chance of it occurring. The term has its origins in visual representations of probability statistics. Grouped in the middle are high-probability events. Distributed more sparsely on the ends - or the tails - of such graphs are events with just a half percent probability of occurring.

Protecting against these tail risks is Wall Street's latest pitch.

Flaws in the reasoning

Being prepared is good. Hedging risk is good. And yet, the "tail risk" sales pitch seems to cross the line from effectively managing risk to simply preying on people's fears.

After all, there is no reason to believe these tail risk investments will actually pay off in the event of a disaster. On the other hand, there are reasons to doubt the approach:

  1. Almost by definition, those low-probability, catastrophic events are hard to foresee. In other words, how do you know you are hedging against the right tail risk?
  2. The complex investment strategies involved might not work correctly - especially in a time of financial upheaval.
  3. The cost of hedging can be prohibitive. One investment pro recommends investing 1 percent of your portfolio to guard against tail risk. If you invest 1 percent to guard against events with a half-percent chance of occurring, you'll quickly run out of money to invest in more likely outcomes.

Ultimately, at a time when stock returns come in fits and starts, bond yields are low, and interest on savings accounts is even lower, investors can ill afford to spend anything on what is essentially a form of insurance with very questionable effectiveness.

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