Are Your Tail-Risk Estimates Reliable?

Few aspects of risk management come with higher stakes than estimating tail risk.[1] Just as a chain is no stronger than its weakest link, an investment strategy will be judged (at least in part) by the depth of its biggest losses. Unfortunately, tail risk is one of the toughest challenges for investment analysts for a simple reason: the supply of data for studying extreme events, by definition, is scarce.  

In some cases, there may be just enough historical data to offer a hint of how returns behave at the outer edges of worst-case scenarios. The deepest 1% losses, for example, are a rare breed in terms of data points in a given track record. That’s well short of what’s necessary for developing a robust estimate of tail risk.

The challenge is made even more daunting for testing new portfolio management strategies. A backtest can help, but it’s only one path of many that can be taken. In fact, it’s fair to say that drawing conclusions from the past (either through historical numbers or a backtest) is a blunt tool at best for developing context on how much damage the next black swan event[2] will unleash on an otherwise well-behaved strategy. Overlooking this issue can get you into all kinds of trouble.

Searching for Extremes

A recent study demonstrates that a poorly thought-out backtest can be deeply misleading. “Many investment strategies such as risk-premia strategies are (back-)tested using historical data,” note Enoch Cheng (University of Colorado, Denver) and Clemens Struck (University College Dublin) in “Time-Series Momentum: A Monte Carlo Approach.” That’s an obvious first step, but it shouldn’t be the last. Why? Stuff happens, as they say.

The research literature (along with common sense) “emphasize the importance of tail events for understanding risk-premia,” the authors remind. But there are several traps lying in wait when navigating this analytical path. Historical data, they advise, “contain few tail events, making it difficult for a backtest to assess i) the true risks involved in a strategy and ii) the chances of a strategy to outperform a benchmark in the long-term.”

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Disclosure: Please Remember That Past Performance May Not Be Indicative Of Future Results. Different Types Of Investments Involve Varying Degrees Of Risk, And There Can Be No Assurance That The ...

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