Tail Risk - Is It Part of Your Investment Framework?

[Viking]

The war in the Persian Gulf makes the discussion of tail risk timely. How do other board members think about this topic?

 

Please note, I am not being a doomer here - I am not suggesting investors should head for the hills and move to 100% cash. Rather, I am simply wondering how board members think about the topic. It is rarely discussed... likely because it is generally best to ignore it.  

 

I find the topic to be very interesting. Because I think financial markets often get tail risks wrong. Which can create mouth watering opportunities for investors.  

 

My base-case assumption is the situation in the Persian Gulf gets 'resolved' (by 'resolved' the Straight of Hormuz gets opened and shipping returns to normal). But I thought this same thing 2 weeks ago - and so far I have been completely wrong...   

 

Tail Risk - Surviving What You Cannot Predict

 

“The stock market is there to serve you, not to instruct you.” — Warren Buffett

 

Introduction: The Wrong Question

 

When geopolitical events emerge—such as the current conflict in the Persian Gulf—the instinctive investor question is:

 

What should I do?

• Buy?
• Sell?
• Hedge?
• Get defensive?

This is the wrong starting point.

 

The right question is:

 

What kind of event is this—and how does it fit within my framework?

 

The conflict in the Persian Gulf is not a standard, forecastable variable.

It is a tail risk.

 

And tail risks require a fundamentally different way of thinking.

 

What Is Tail Risk?

 

Tail risks are low-probability, high-impact events that reside at the extreme ends of a probability distribution.

In most environments:

• Outcomes cluster around expectations
• Volatility appears manageable
• Risk feels quantifiable

Tail events violate all three.

 

They are:

• Unexpected (relative to models)
• Discontinuous (they do not unfold smoothly)
• Systemic (they affect multiple variables simultaneously)

Markets are not undone by what is expected—but by what is dismissed.

 

 

The Buffett Lens: Focus on Survivability

 

Buffett’s framework is not built on predicting tail events.

It is built on ensuring they do not destroy you.

 

Core principles:

 

1. Avoid permanent capital loss

• Not volatility—permanent impairment

2. Maintain financial strength

• Low leverage
• High liquidity
• Durable balance sheet

3. Stay within your circle of competence

• Avoid exposures you do not fully understand—especially under stress

4. Preserve optionality

• Cash and liquidity are not inefficiencies—they are strategic assets

 

“You only find out who is swimming naked when the tide goes out.” — Warren Buffett

 

Tail events are when the tide goes out.

 

Why Tail Risks Matter Disproportionately

 

Non-linearity of losses:

• A -50% drawdown requires +100% to recover.
• Compounding works against you.
• Destruction of the capital base
• Large losses reduce future earning power.

Breakdown of diversification

 

In stress:

• Correlations → 1
• Liquidity disappears
• Forced selling dominates

Model failure

 

Standard risk tools assume:

• Normal distributions
• Stable relationships
• Continuous markets

Tail events break all of them simultaneously.

 

Historical Pattern: Ignored Until It Isn’t

 

Markets repeatedly demonstrate the same behavioral flaw:

 

They ignore risk—until they can’t.

 

Case Studies

 

2008 Global Financial Crisis

• Structural fragility in housing and credit was visible. Action came only when collapse was unavoidable.

2020 COVID crash

• Information was available for months. Markets reacted only at the point of exponential spread.

1987 Black Monday

• A statistical impossibility—until it happened.

LTCM (1998)

• Highly sophisticated models undone by correlation convergence and leverage.

Bond bubble peak (2020–2021)

• Extreme duration risk ignored in a zero-rate environment.

Dot-com bubble

• Valuation discipline abandoned until the system reset.

 

The lesson:

 

Tail risks are often observable in advance—but not acted upon.

 

The Structural Drivers

 

Tail events typically emerge from hidden fragility:

• Leverage
• Small shocks become existential threats.
• Liquidity illusion
• Assets assumed liquid cannot be sold without severe price impact.
• Correlation convergence

Diversification fails when it is needed most.

 

Reflexivity

 

Selling triggers more selling. Feedback loops accelerate outcomes.

These forces are always present.

Tail events simply activate them simultaneously.

 

The Core Investor Problem: How should you respond?

 

In most cases:

 

The correct action is to do nothing.

 

Because:

• Tail risks rarely materialize
• Timing them requires two correct decisions:
  • When to exit
  • When to re-enter

Few investors consistently achieve both.

 

When “Do Nothing” Is Wrong

 

The answer is situational.

 

It depends on the tail risk (the Great Financial Crisis being perhaps the best example). 

 

And it depends on each investor's individual situation:

• Time horizon (age)
• Psychological (tolerance for volatility)
• Financial objectives (maximize return or preservation of capital)
• Portfolio structure
• Portfolio size (are you just getting started or have you already won the game?)
• Tax considerations

There is no universal rule. And that is what makes the topic so interesting.

Edited March 22 by Viking

[frommi]

Agree, for most people doing nothing is the right call. I am afraid that someday 1929-1933 repeats so i hedge from time to time, especially since it helps me stay fully invested. Over the past 10 years the hedging has reduced my returns by ~-1%/year. I had two great years in 2015 and 2018 where the puts paid off, but after those a lot of loss-years with the hedges. 
What i typically do is buy Dec Put options on the DAX index at the end of april ( Sell in may  ), 5% out of the money and a 5% position. Its held until end of october or until its a 5-bagger (which happens at a 20% drawdown). This of course missed the covid crash, because it happened in march  . 
This moves a possible 5% return in a good year to a 25% win in a bad year. Often the puts still have residual value at the end of october, so even when the crash doesnt happen, not all is lost.

Else when i think the market is truly ripe for a correction and my market timing signals are flashing red i also buy puts on other indices, but typically smaller positions. (1-2% of the portfolio)

So in the long run the hedging doesnt really add value outside of the psychological effects. (And of course you feel like a hero when the crash really happens, but dumb when not 

Edited March 22 by frommi

[Viking]

1 hour ago, frommi said:

Agree, for most people doing nothing is the right call. I am afraid that someday 1929-1933 repeats so i hedge from time to time, especially since it helps me stay fully invested. Over the past 10 years the hedging has reduced my returns by ~-1%/year. I had two great years in 2015 and 2018 where the puts paid off, but after those a lot of loss-years with the hedges. 
What i typically do is buy Dec Put options on the DAX index at the end of april ( Sell in may  ), 5% out of the money and a 5% position. Its held until end of october or until its a 5-bagger (which happens at a 20% drawdown). This of course missed the covid crash, because it happened in march  . 
This moves a possible 5% return in a good year to a 25% win in a bad year. Often the puts still have residual value at the end of october, so even when the crash doesnt happen, not all is lost.

Else when i think the market is truly ripe for a correction and my market timing signals are flashing red i also buy puts on other indices, but typically smaller positions. (1-2% of the portfolio)

So in the long run the hedging doesnt really add value outside of the psychological effects. (And of course you feel like a hero when the crash really happens, but dumb when not 

@frommi, thanks for sharing. My basic strategy has been much more simple… when my ‘spidey sense’ starts to tingle I ‘buy cash.’ If the situation continues to deteriorate, I but more cash. The part that has always amazed me is financial markets tend to always look through the tail risk - markets stay high. This has helped me - as it provides time to collect more information and assess the situation. And usually gives me ample time to get my cash weighting to where I want it.
 

I also think a person’s personal situation is quote important to this topic. 
 

As an example, I am:

• Retired
• More risk averse than when I was younger
• I have won the game (I have enough)
• My goal has shifted to capital preservation from return
• Most of my investments are in self directed tax free accounts. Transaction costs are near zero. And i don’t need to think about taxes. This gives me a great amount of flexibility (makes it very easy to move to cash and then to become fully invested again).
• My spouse is very risk averse 

Over the past 30 years I have been able to largely avoid every major market sell off. My guess is that has helped my returns. 
 

Where I have messed up is on the buy side after a big meltdown - often, I have been too pessimistic (slow to buy back in). My plan this time around is to scale back in using broad based index funds like XEQT. This gets around the problem of what to buy/circle of competence. 

Edited March 22 by Viking

[scorpioncapital]

I don't know if this is an appropriate 'method' but what I do is take the average return for the SP500 and for cash, then I look at my portfolio and see what returns I have gotten above or below. If it is way above, I cut down on the assumption that excess returns are precisely hard to achieve because of tail events, among other issues like poor stock selection skill. If it is way below , I look to see if I have things like cash, gold, real world assets that could be useful in a crisis and tend to keep those. Although lately I would say most people are above the index. If you hold only the index, then I would shift the analysis to the % held in the index vs held in cash/gold/bitcoin. Risk is an invisible variable. That is precisely why people have very little patience with it - as they cannot see it immediately. Good investors probably hedge by purposely seeking uncorrelated or low return assets that preserve more than gain from the risks of this 'invisible tail-risk' hand which just can't be seen for long stretches. It then pounces just when you get overconfident lol.

 

Edited March 22 by scorpioncapital

[frommi]

The problem with this all weather approach of chosing different assets like bonds or gold is that in a real crisis like 2008 or even last week all correlation go to 1 and everything goes down together because of people seeking liquidity. 
I tested all kinds of methods of hedging, puts on indices, puts on single stocks, gold+bonds, cash, naked shorting futures, naked shorting stocks. The last two methods fell out pretty easily because if the market moves against you your hedge gets bigger which is never a good thing. You want your exposure to get smaller when you are wrong.

Puts on single stocks didnt work because the good shorts already have high IV, its all baked into the option price. And typically they arent a good hedge either because they dont necessarily move with the market. Cash also reduces your returns, so there is not that much difference to systematically buying puts.

 

But like Viking mentioned the hard part is when to sell the hedge or when to get back in. I think one needs hard rules for this, like VIX>50 or after a 20% drawdown, or else there is the risk that one never gets back in. 

 

With puts there is also the danger of bleeding out over time if you for example always sell after a 50% gain but your puts expire worthless from time to time the whole endeavour will be loss making because you have to be right 66% of the time just to stay flat which is nearly impossible over the long run on the short side. Your puts have to be multibaggers to carry the losses.

I see myself also as retired even if i still work part time, so my risk appetite is not that high, but at the same time i want good returns which needs a balance between offence and defense. 

Edited March 23 by frommi

[SharperDingaan]

Way more rabid than most  ....

 

As do many others, we primarily use cash/BTC/bonds to handle the tail risk. We give up some upside to hopefully avoid most of the downside; insurance. Where possible, re-entry via warrants, LEAPS and calls in the same stocks; all very conservative.

 

Then, very occasionally, a material disruption threatens (war, expropriation, etc) ..... and we play rough hockey. Gloves off offence, winner take all, life changing gains; expectation that we lose everything at home, more than make it back elsewhere, but will need to start again ... ahead of where we were. BTC for good reason, and very hard to kill. Should it ever happen; ideally, we don't lose our home .... and are just very well paid for our risk tolerance, expertise, and experience .

• Not long after completing university, I partnered with friends to undertake an "adventure in the nature of trade"; to quietly bulk buy clothing out of a former soviet military warehouse on the Baltic coast (Glasnost/Perestroika time), resell it in the west, and keep the gains. More familiar with the dark arts, I was one of those doing the on site 'negotiation'. One of the takeaways was that while the people overall were incredibly kind, it was hard to ignore the ingrained poverty, .... and we all swore it was never going to happen to us.

• A long and winding path later we ended up with 672 premier tickets to the most prestigious Millennial Ball in Vienna, a once in a century all night tuxedo/gown event, that really had to be experienced to be believed. Spouse and I unable to go ... as we had to babysit and test Y2K rollovers that went flawlessly . The event of the f******* century, and we swore it was never going to happen to us again!    

Point here .... enjoy the rewards as well !

 

SD

 

 

 

  

 

Edited March 25 by SharperDingaan

[flesh]

I’ll just add for those of us that don't already know. 
 

Own something like Brk which has its own massive cash pile as a % of mkt cap which has the will and desire to buyback stock, buy stocks, buy companies outright at depressed prices is a good hedge. Not quite the diversification as s and p (debatable if mkt cap weighted) however very diversified. 
 

unfortunately, they weren’t as aggressive as we would have liked during covid but they did do the above mentioned things. Presumably they’d have been more aggressive if things were worse than -20% indexes.

 

Hopefully Greg will be more aggressive in the future.  
 

 

 

Edited March 24 by flesh

[Blake Hampton]

"The closer someone sits to the commodities desk, according to one trading boss, the more freaked out they tend to be."

- The Economist: Markets are gripped by an alarming cognitive dissonance

 

In my mind, a systemically threatening tail risk almost always revolves around credit. It is the bottleneck at which cumulating financial events can turn from something bad into something catastrophic. Credit is the blood that flows throughout our financial system, whereas our banks are something akin to a heart. When something is severe enough to cause deep distress in our banking system, that ultimately creates a block around general accessibility to credit, it results in what is the economic equivalent of a heart attack.

 

I think about stuff like that nearly every day.

 

I also personally think what's happening currently in Iran is really bad. We have a liar-in-chief who can't be trusted with almost anything he says, and we have a situation where the incentives are extremely misaligned to anything resembling a good outcome.

 

But I could be wrong. I've been wrong many times so far. But I also have a strong feeling that Trump will keep up with the chaos.

[Blake Hampton]

I think the best asset to hold for my type of tail risk is cash. In times of great stress with credit, especially in an economy as leveraged as ours is today, there can be a "dash for cash" as everyone scrambles for liquidity all at once. This is almost always when the best buying opportunities occur. And the Federal Reserve can play a big role in times like this.

 

Of course you can have a tail risk, like the Dot-Com Bubble for example, that doesn't ultimately threaten the system because it's not tied up in credit.

Real estate is always interesting to me because the foundation of that market is tied up in credit. But I imagine there are scenarios where a real estate crash wouldn't be systemically threatening either. It does seem harder to imagine though.

 

It's all interesting anyway.

[gfp]

What I'm curious about is if Blake will sell his oil investments during this oil price spike or actually buy anything during a true panic with the cash position.  In a "dash for cash" your cash only becomes more potent if you spend it.  It doesn't show you a profit on its own - you have to be willing to abandon your security blanket when everybody is panicking.

[Gregmal]

1 minute ago, gfp said:

What I'm curious about is if Blake will sell his oil investments during this oil price spike or actually buy anything during a true panic with the cash position.  In a "dash for cash" your cash only becomes more potent if you spend it.  It doesn't show you a profit on its own - you have to be willing to abandon your security blanket when everybody is panicking.

This has nothing to do with Blake, but what I’ve noticed is that when everybody is panicking, these people that were panicking when no one else was, are still panicking the hardest. It’s only in the movies where they’re sitting calmly with a daiquiri getting ready to pick up all the bargains.

[Castanza]

9 minutes ago, Blake Hampton said:

I think the best asset to hold for my type of tail risk is cash. In times of great stress with credit, especially in an economy as leveraged as ours is today, there can be a "dash for cash" as everyone scrambles for liquidity all at once. This is almost always when the best buying opportunities occur. And the Federal Reserve can play a big role in times like this.

 

Of course you can have a tail risk, like the Dot-Com Bubble for example, that doesn't ultimately threaten the system because it's not tied up in credit.

Real estate is always interesting to me because the foundation of that market is tied up in credit. But I imagine there are scenarios where a real estate crash wouldn't be systemically threatening either. It does seem harder to imagine though.

 

It's all interesting anyway.

I’ll take an irreplaceable business with a fortress balance sheet that throws of lots of free cash flaw over holding t-bills any day any in market environment outside of a small cash position for buying opportunities. The world still has to tick…the mentality you have isn’t going to serve you well if we ever get the big one. It will just lead you to believe there is more downward pressure to come and you’ll try to perfectly time the bottom and end up sucking your thumb. If you did nothing but invest at market tops you still would do well over 30-40 years. 

[Blake Hampton]

6 minutes ago, gfp said:

What I'm curious about is if Blake will sell his oil investments during this oil price spike or actually buy anything during a true panic with the cash position.  In a "dash for cash" your cash only becomes more potent if you spend it.  It doesn't show you a profit on its own - you have to be willing to abandon your security blanket when everybody is panicking.

See one of the problem now is that what everyone thinks is a true "dash for cash" isn't. The "panic" we saw last year revolving around tariffs was a baby fart compared to what I think a true panic looks like.

[Gregmal]

Anyone remember who that jamoke was on CNBC(or maybe Bloomberg) in early 2009 saying that from 680 SPY or whatever that we still have about another 20-30% to go before bottoming?

[Blake Hampton]

Also something important to understand is that in a fractional reserve banking system, most money essentially is credit. A reoccurring mark of systemic shocks is deflation as the effective money supply rapidly shrinks. These are the times where companies with poorly managed balance sheets can die due to a lack of liquidity.

 

"Only once in the past century, in the 1930s, have we had deflation, serious deflation. In 2008-2009 there was cause for concern. The common characteristic of those two incidents was collapse of the financial system."
- Paul Volcker, Keeping At It

[Castanza]

@Blake Hampton you’re like the financial version of evangelicals that think every outbreak of violence in the Middle East is a sign of the second coming of Christ and the ushering in of the tribulation. 
 

 

[brobro777]

No dude when I'm trading ES and NQ I don't consider this risk: https://www.youtube.com/watch?v=BODzZUUO-s0

 

haha

 

 

[UK]

7 hours ago, Blake Hampton said:

See one of the problem now is that what everyone thinks is a true "dash for cash" isn't. The "panic" we saw last year revolving around tariffs was a baby fart compared to what I think a true panic looks like.

Then I suggest you to play this true panic thesis with something like max 30-40 percent cash allocation. If you can find anything giving you >10-15 expected returns, just stay invested at min 60-70 percent. This way, in a true panic scenario, possibly also by adding some leverage, you will have almost 50 to 70 per cent dry powder to deploy (and test you panic investing abilities), but such positioning also will not kill you, if the true panic never comes or comes 5-10+ years too late. And better focus your time on the ideas for the 60-70 portfolio part, then worrying about some general fears, it will be more productive and ejoyable

[nwoodman]

Great post. While I try to identify and handicap the tails, knowing what you own and margin of safety are key. I'd add one more layer: buy companies with plenty of scar tissue and management that acts rationally.  Then sit tight, and make sure you still have a seat during the inevitable 50% drawdown.

If you find yourself getting excited about volatility and downturns rather than fearful, that's a decent test that you own the right things.

[gfp]

11 hours ago, Blake Hampton said:

Also something important to understand is that in a fractional reserve banking system, most money essentially is credit. A reoccurring mark of systemic shocks is deflation as the effective money supply rapidly shrinks. These are the times where companies with poorly managed balance sheets can die due to a lack of liquidity.

 

"Only once in the past century, in the 1930s, have we had deflation, serious deflation. In 2008-2009 there was cause for concern. The common characteristic of those two incidents was collapse of the financial system."
- Paul Volcker, Keeping At It

 

The "money is credit" point is basically right.  I think you probably miss the multiplier effect of dollar denominated instruments ("USD money")  that are created by offshore banks entirely outside of the US government / Treasury / Federal Reserve / US Banking industry.  These forms of money are extremely large and far more prone to tightening, changing in price, risk aversion behavior, etc.   Think of the US dollar like the metric system - a unit of account - any offshore entity can create instruments that are denominated in this "metric system" - it isn't required that something be an "authentic government created US dollar" for it to effect monetary tightness or loose-ness.

 

I suspect that one of the big reasons Fairfax wanted to make a big bet on deflation (that didn't work out at all for them) was that something fundamentally changed in the GFC around 08-09 that was a step change in the global funding markets.  Post GFC, trust was gone and it didn't matter if you were a blue chip name or Joe Schmo - you had to post collateral for everything and that was a big change.  And good collateral - with haircuts for anything even slightly less than pristine US T-bills.  The size, terms, and circulation of the global eurodollar market was knee-capped and never recovered.  It is still huge - larger than the market for "authentic US dollars" - but dollar funding has been tighter ever since that step change.

 

It's not just the "amount of dollars that exist" that impact "deflationary monetary conditions", tightness or looseness of money.  It is the recirculation or maybe think of it as the "velocity of money" that matters.  Money hoarded because institutions are slightly increasing risk aversion behavior is money that either isn't willing to be recirculated or isn't willing to be recirculated at anywhere near the price it was available at yesterday.  That's why you often hear that "repo markets" are showing stresses below the surface during bouts of tight money - an increase in risk aversion behavior by everybody, especially primary dealers and global eurodollar banks.

 

But deflationary monetary conditions - tight money - is not exactly the same thing as inflation or deflation for consumer prices.  We will continue to have bouts of tight money here and there but governments will not allow deflation to persist to where it shows up in the CPI because our system doesn't function well that way.  Even with all the AI predictions of mass deflation of consumer prices, I don't see it actually happening.  

 

Like you said - our system is built on credit and credit is underpinned by collateral and deflation of collateral doesn't go well.  And deflation in consumer prices, outside of the "good deflation" we saw in technology products for most of our lifetimes, can really slow the economy as people put off buying because prices will be lower next month.

[Saluki]

 

 

I'd been thinking about Tail Risk a lot over the weekend, actually, because my biggest holding, Google, is off about 30% from it's high. I'm still up more and down less than the market, but at this stage in my life I think "not losing as much as downturns and matching in upturns" or "losses matching the market, but outsize gains" is not the best outcome for where I am now. 

 

Long term returns that outperform the index and are uncorrelated is the holy grail. But how? Markopolis said that one of the ways he figured out that Madoff was a fraud is that you can outperform your asset class, but the returns will still be correlated to the asset class you are trading. Fairfax will beat other insurance companies, but when insurance companies are getting hammered, so will Fairfax (but not as much). 

 

If you are worried about tail risk in the market, and your returns will be correlated to the market (even if you outperform), then how do you structure an investment in an asset class (equities of various industries) that will give you a great return but be uncorrelated to the underlying asset class so that you are insulated from tail/risks and black swan events. 

 

At this point it's a thought experiment which is giving me a lot to think about, but I don't have a good answer yet. 

 

[Viking]

“Everybody's got a plan until they get punched in the face" - great philosopher Mike Tyson

 

I find tail risk so interesting because really bad things do happen. The key is to be as rational as possible (which includes being honest with youself). But ‘rational’ is not absolute (what people like me and other board members might post with great confidence should be done). It is relative (what you actually will do when the punch lands).  

Edited March 25 by Viking

[KCLarkin]

29 minutes ago, Saluki said:

I'd been thinking about Tail Risk a lot over the weekend, actually, because my biggest holding, Google, is off about 30% from it's high.

Google seems to be in a ~15%-17% drawdown. That is pretty standard volatility. 

 

[brobro777]

1 hour ago, Saluki said:

 

 

I'd been thinking about Tail Risk a lot over the weekend, actually, because my biggest holding, Google, is off about 30% from it's high. I'm still up more and down less than the market, but at this stage in my life I think "not losing as much as downturns and matching in upturns" or "losses matching the market, but outsize gains" is not the best outcome for where I am now. 

 

Long term returns that outperform the index and are uncorrelated is the holy grail. But how? Markopolis said that one of the ways he figured out that Madoff was a fraud is that you can outperform your asset class, but the returns will still be correlated to the asset class you are trading. Fairfax will beat other insurance companies, but when insurance companies are getting hammered, so will Fairfax (but not as much). 

 

If you are worried about tail risk in the market, and your returns will be correlated to the market (even if you outperform), then how do you structure an investment in an asset class (equities of various industries) that will give you a great return but be uncorrelated to the underlying asset class so that you are insulated from tail/risks and black swan events. 

 

At this point it's a thought experiment which is giving me a lot to think about, but I don't have a good answer yet. 

 

 

I read about guys who printed money during the 70s by focusing on commodities but then didn't do so hot in the 80s and 90s because the action moved on to equities and they didn't adjust. Then equities were great for decades while commodities crashed (British unloading gold for less than $300 https://en.wikipedia.org/wiki/1999–2002_sale_of_British_gold_reserves). Then for a decade from 2000 to 2010, SPX had a negative return while commodities were ripping - I remember reading Jim Rogers' Hot Commodities during this time. So the juice moved from asset classes and how to protect against this? Maybe having a multi disciplinary approach like Charlie Munger to have wider view of things, I think helps

 

More importantly though you gotta be wary of the dumpster juice smell of BBLs - https://www.youtube.com/watch?v=qYPBKTVO7us&t=1299s - dumpster juice

 

haha

 

 

[SharperDingaan]

Tail risk is just part of life. We can do the Taleb Bar-Bell (long straddle) and make it work for us, or try to do our best to avoid it.

It's a much richer life taking on risk (love, adrenaline sports, etc.), than living under a rock hoping the sky doesn't fall.  

 

Evolution is constant; so it should not be surprising that what worked well last cycle, maybe doesn't today. 

 

SD