Specifying and Managing Tail Risk in Portfolios - A Practical Approach

Abstract

Tail risk arises at multiple stages in the investment management process – from the high level asset allocation decision down to the individual portfolio manager’s process for selecting securities. We believe that conventional practices followed in these investment decision processes, largely ignore intra-horizon risk. We believe this leads to sub-optimal assessment of risk of assets, particularly in the context of potential tail risk, and leads to the construction of portfolios, which are not in sync with the risk aversion of the client.In the present paper we propose a composite risk measure which simultaneously captures the risk of breaching a specified maximum intra-horizon drawdown threshold, as well as the risk that the performance is not met at the end of the investment horizon. We believe this captures the ‘true’ risk of a portfolio, much better than traditional end of horizon risk measures.We find that intra-horizon risk can represent a substantial part of the total risk, and thus needs to be managed explicitly which constructing a portfolio of assets, strategies or asset classes. We propose that varying the investment horizon and implementing a customized stop loss for each asset can help construct a portfolio where portfolio risk is kept within bounds of tolerance, and can improve performance over time.