Tail risk, or the risk of suffering losses greater than statistically normal ranges, is a much greater threat to portfolios than volatility, global asset manager AllianceBernstein warns.
Tail risk takes its name from the shape of the bell curve, in which statistically normal outcomes fall along the "dome" of the bell and extreme outcomes tail off at either end, with negative outcomes on the left and positive ones on the right.
"The problem with the concept of volatility as it is typically understood by risk-aware investment strategies is that it assumes a normal pattern of returns, such as that described by the bell curve diagram of probable outcomes commonly used in statistics," said Michael DePalma, AllianceBernstein's New York-based chief investment officer for quantitative investment strategies, during a visit to Australia this week.
"But we know from experience-particularly since the 2008 financial crisis-that extreme outcomes are likelier in reality than the probability implied by a normal distribution."
According to AllianceBernstein research, negative tail events have occurred more frequently in global financial markets in recent years than would historically be expected - a total of nine tail events have occurred since 1988 instead of the anticipated six.
To help investors mitigate the losses from tail-risk events, and at the same time achieve consistently positive investment returns across the investment cycle, AllianceBernstein has launched a strategy known as Tail-Risk Parity (TRP).
"TRP takes the concept of risk parity, in which capital is allocated so that each asset-class contributes equally to overall portfolio volatility, and improves upon it by rejecting volatility as the measure of risk, using tail risk instead," explained DePalma.
"TRP uses signals from the option markets, rather than historical price data, as a guide to expected tail losses."
AllianceBernstein was helped in the development of this forward-looking methodology by Nobel Laureate Myron Scholes, co-creator of the Black-Scholes option pricing model.
"We believe that TRP can help deliver balanced portfolios that cost-effectively reduce exposure to tail losses at times of market turbulence and which can also participate in market upside during more normal conditions," said DePalma.