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This episode aired on Bloomberg TV on Sep 24, 2013

Left Tail Risk

Q. So “left tail risk” was getting tossed around a lot at the investor conference you attended yesterday. First off, let’s recap what tails we’re talking about here…

A. Maybe we should have Richard Falkenrath do this one, but here goes: a normal bell curve shows the probability of outcomes. The most likely are bunched in the middle, the bubble portion of the curve. On either end, the liklihood trails off into what folks call “tails”…. here’s a graph that shows it well.

Q. So let’s discuss this for a second. The tails of a traditional distribution curve are very close to that bottom line– so that shows very little risk that those extreme events would happen?

A. Right… and here we also have another line that shows the tail higher up off that bottom line. That means extreme events are more likely than in a typical curve, so we say that probability curve has a “fat tail”.

Q. And… for investments, it looks like “left tail risk” means the risk of big losses.

A. Yep. So in a really ideal world, you’d hedge out the left tail risk, and keep the chances for big gains from right tail risk in place.

Q. OK, and so “left tail risk” was a big topic yesterday… why?

A. Well, there was a lot of talk about the unforeseeable consequences of the taper, political gridlock, etc., and that maybe folks need to pay attention– because left tail investment events seem to happen more and more frequently… as this chart shows…

Q. At least a couple big ones per decade since the 80s. So how do people hedge that out?

A. Lots of ways, but buying very cheap, way out of the money put options might be the most common. Of course, cash works too: wait for the crash and then buy in the panic… lots of fortunes have been made that way.