Squire Approach

Truncating the Tail: A Risk Management Strategy For Up And Down Markets

It takes a long time for an investment to recover from a major crash. The growth needed to offset a decline grows exponentially with every percentage point lost. One particularly effective risk management strategy is to avoid both the market's highest highs and lowest lows. The action, called truncating (to cut off) the tail, of trying to avoid the lowest lows, may mitigate negative extremes.

Truncating the Tail: Planning for Good and Bad Markets

Buy a good investment and hold it forever.

The flaws associated with this timeless industry rule were exposed by the crash of 2008.

By truncating the tail—working to avoid the most extreme losses and the exponential growth required to offset them—those investors could have instead captured that growth as profit that buy and hold investors needed for recovery.

For investors, the most extreme losses and gains are called tails. By cutting off—or attempting to truncate—negative tails, investors might dramatically reduce their exposure to the risk of major, exponential losses. On a bell curve that college professors use to make grading more equitable, the A’s and the F’s would be the tails.

It is a strategy that, unlike most plans—and certainly unlike the buy-and-hold philosophy—prepares to manage investments in both up and down markets.

CVaR: The Yardstick That Measures the Tail

Truncating the tail is a strategy designed to avoid the very worst losses. In order to do that, investors need a measurement to gauge just how bad any given crash could become.

Many financial firms use the Value at Risk (VaR) methodology, which is a simpler tool used to analyze the potential for loss based on historically bad days or weeks. Many financial plans are based on Value at Risk, or what happens to money in normal or average markets. It’s difficult to get a financial model to behave in both average markets and volatile markets.

A more sophisticated approach is CVaR: Conditional Value at Risk.

CVaR is VaR evolved. It considers the most extreme potential losses, and is therefore best equipped to measure a strategy based on truncating the tail. CVaR methodology considers that:

  • Extreme losses can happen.
  • Extreme losses can happen regularly.
  • Extreme losses can be worse than expected.
  • Extreme losses can take a lot longer to recover than expected.

Many firms and professionals refer to the Great Depression as an outlier—something that doesn't happen often and is highly unlikely in the future. That is simply not true in the case of foreign markets, and extreme losses batter domestic stocks, commodities and indexes with regularity. Look no further than the oil crash of 2014-16 for a perfect example.

Investors who bought oil at $140 and held throughout the crash suffered Depression-esque losses nearing 90 percent. It could take them years to recover—if they ever recover at all. If they had planned for both good and bad markets by truncating the tail, those investors might have mitigated the most extreme losses and potentially captured as profit, money that they were forced to lose and recover, by selling high and buying low.

It is not possible to determine the top or the bottom of the market.

Investing in the market involves risk, including fluctuating prices and the uncertainty of return. There is no guarantee that the investment strategy discussed will be successful.

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