Tail Events
By Tim Egart, CFP®
Have you glanced at world markets in the last few months? It can be hard to avoid, particularly with daily headlines touting the volatility on any given day. Let’s take a look at a few definitions that will help give some context to what we’re seeing and how to respond.
Standard deviation is a measure of variation around a mean set of values. The higher the standard deviation, the higher the dispersion between events. The lower the standard deviation, the tighter events coalesce around the mean. Often, standard deviation can be visualized through a distribution curve like the one below.
Source: Wikipedia
When it comes to the markets, we use standard deviation to measure how volatile a portfolio might be. For each risk/return profile, we can model projected volatility to help investors understand how good/bad a portfolio might perform under a variety of circumstances. To be more specific, ~95% of market returns for a given allocation will fall within two standard deviations of the mean or expected return. The wider the distribution curve, the farther events will spread from each other. While we can use available data to model expected performance, we cannot ever conclusively predict those results. There will always be tail events that live outside of most circumstances. A “tail event” is at the furthest ends of a distribution curve and represents a low probability, but not a no probability, outcome.
Now that we’re all caught up on Finance 101, I trust everyone remembers the market experience in March ’20 while COVID was ripping across the globe… The S&P 500 fell ~34% in 5 weeks. We remember the Dot-Com Bubble and the Financial Crisis of 2008. These market experiences took our breath away and would be considered tail events (low-probability events) when it comes to the historical market experience.
While the downdraft we’re currently experiencing in equity markets is statistically what we believe is normal at current levels, it does help to remind us all how we respond during significant volatility. For long term investors, negative tail events can be opportunities for long-term wealth to be created, though it doesn’t always feel that way. These seasons of pain disguise the buying opportunity wrapped in the face of fear, uncertainty, and doubt. Proper allocations are designed for maintenance through these periodic tail events, which means that our discipline and emotions become the arbiter of our future.
In the Psychology of Money, Morgan Housel wrote that “doing well with money has little to do with how smart you are and a lot to do with how you behave” and that “a genius who loses control of their emotions can be a financial disaster.” With studies showing the average investor feels the pain of losses two times greater than they feel the joy of gains, we’re fighting an uphill battle against ourselves when markets fall. When experiencing heightened volatility, it’s important to stay disciplined to an investment structure and limit the control our emotions have over our actions. In the midst of it all, we’re here to walk with you through the joy of gains, the pain of losses, and everything in between.