Living with 'fat tails' and coping with risk

If 2011 is proving anything to investors, it's that they may have to put up with a world of repeated economic and political shocks -- but the caution this produces may benefit the global economy in the long term.

As the first quarter of the year comes to a close, the dominant talking point among asset managers is just how unpredictable world events have been this year, and how funds may need to brace themselves for an era that continually throws up such low-probability, market-moving developments.

At the turn of the year, it would have been impossible to forecast domino-like unrest across the Middle East and North Africa, the resulting oil price spike, and this week's United Nations-backed military intervention in Libya.

Japan's 9.0-magnitude earthquake, devastating tsunami and nuclear scare, while not inconceivable, could hardly have been on anyone's list of first-quarter scenarios.

Living with fat tails

But so-called "tail risks" -- named from the bell-shaped graph showing a normal distribution of possible outcomes, with the two "tails" representing low-probability extremes -- are central to investor thinking since the global credit crisis of 2007-2009.

The credit bubble and its dramatic implosion were blamed partly on an underestimation of extreme risks to investment portfolios. Low volatility measures and risk gauges before the crash encouraged excessive risk-taking, which was followed by a stampede for safety when the unpredictable chain of events materialised.

But if the probabilities of extreme events are higher than previously thought -- or tails are fatter, in the jargon -- then the market may just have to adapt, via more flexible and adept management of portfolios, greater use of insurance and derivatives, or even wider diversification of assets.

If that prevents extreme investment behaviour, it could be positive for a wide range of financial markets and economies.

And although the credit crisis has been described as a "black swan" event -- an outcome impossible to conceive and hence model -- investors may be less complacent if they now realise that the future can be entirely unpredictable.

Unstable, volatile word

Many fund managers attending Axa's Investment Managers' annual economics symposium on "Post-crisis Globalisation" in London last week felt a high number of tail risks would define the years ahead.

"This is just something we're going to have to live with," said Mark Tinker, global equity portfolio manager at Axa.

Giordano Lombardo, chief investment officer at Pioneer Investments, told Reuters that his firm's recent launch of Absolute Return funds -- which use more transparent and risk-sensitive hedge fund strategies that include going both long and short in markets -- was one response to the outlook.

Lombardo said the investment world would face a low-return but more volatile environment in the years ahead as a result of global economic imbalances, the vagaries of extreme monetary policies, unstable public debts and high geopolitical risks.

"Clearly there is some link between heightened geopolitical tension and structural flaws in the world economy, even if it's difficult to give just one point of causation, " he said.

"We believe we are moving into a more unstable world. That will involve more trendless, volatile markets -- but markets which are not without opportunities."

This new environment may hurt the global economy by imposing higher insurance costs and greater price volatility while making investors less optimistic.

But the global economy could actually benefit if cautious investors now avoid the type of irrational and dangerous exuberance seen in the credit bubbles of 2005 and 2006. The new mood of caution could act as a financial regulator of sorts.

Wall Street's VIX index of implied volatility in S&P 500 stocks currently paints a picture of average volatility almost twice the pre-credit crisis lows -- but with lower peaks of volatility in shocks since the crisis.

The Lehman Brothers collapse saw volatility as high as 80%. The Greek crisis saw it peak close to 50%, while the index crested just above 30 percent after the Japan quake.

"Although "black swan" events are rare, they are vital for successful investments. They cannot be avoided, but investors can sidestep them with a good diversification strategy," Peter Bezak, portfolio strategist at Zurich-based asset manager Sarasin told clients this week.

"Investors should be aware of the portfolio risk and include the possibility of extreme situations in their deliberations. This is the only way for investors to survive these situations and maintain their long-term strategy until the market recovers, which usually occurs not long after."