In layman’s terms, Fat Tail Risk is the low probability of assets suffering a decline in value of significant magnitude. Since these low probability / high magnitude market events can be devastating to portfolio value, many investors refer to the experience of a Fat Tail Risk event as a “permanent impairment of capital”. In capital markets, appreciation of Fat Tail Risk for most investors tends to ebb and flow in cycles that correlate to general market volatility. In other words, market participants tend to have short memories when times are good.
As an investor, it’s important to exercise constant vigilance when it comes to defending against Fat Tail Risk. Depending on the risk asset, protecting portfolios from Fat Tails can be achieved by a number of methods, including hedging and diversification. This protection comes at a cost though, and will generally be a drag on portfolio returns over time…until it is needed. A good analogy is your homeowner’s insurance. The premiums you pay are an expense that go with owning a home, and most people will be fortunate to never make a claim. However, if the low probability fire, tornado, or other event occurs that renders your home a total loss, you’ll think back at how glad you were to make all those premium payments.
