Specifying and Managing Tail Risk in Portfolios - A Practical Approach

Posted: 28 May 2013 Last revised: 27 May 2015

Date Written: May 28, 2013


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.

Keywords: risk, tail risk, drawdown, intra horizon, volatility, asset allocation, portfolio construction

JEL Classification: G1, G3

Suggested Citation

Gupta, Pranay and Skallsjö, Sven R., Specifying and Managing Tail Risk in Portfolios - A Practical Approach (May 28, 2013). Available at SSRN: https://ssrn.com/abstract=2270914 or http://dx.doi.org/10.2139/ssrn.2270914

Pranay Gupta (Contact Author)

Allocationmetrics Limited ( email )

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Hong Kong, 00000
Hong Kong
852 6778 0258 (Phone)

HOME PAGE: http://www.allocationmetrics.com

Sven R. Skallsjö

Independent ( email )

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