The firm has said managers should look beyond this measure of risk and consider factoring into their investment choices a potentially more destructive threat: tail risk.
‘Tail risk’ includes the risk that investors will experience losses on their portfolios that lie outside that which, statistically, is regarded as normal.
“The problem with the concept of volatility as it is typically understood by risk-aware investment strategies is that it assumes a normal pattern of returns, such as that described by the bell curve diagram of probable outcomes commonly used in statistics,” said Michael DePalma, AllianceBernstein’s New York-based chief investment officer, quantitative investment strategies.
“But we know from experience, particularly since the 2008 financial crisis, that extreme outcomes are more likely in reality than the probability implied by a normal distribution,” he added.
Tail risk takes its name from the shape of the bell curve, in which statistically normal outcomes fall along the ‘dome' of the bell and extreme outcomes tail off at either end.
According to the firm, a negative tail event should have occurred in global financial markets six times since 1988, but in reality they have occurred more often.
To help investors mitigate the dangers of these events the firm has launched a strategy known as Tail Risk Parity (TRP).
“It takes the concept of risk parity, in which capital is allocated so that each asset class contributes equally to overall portfolio volatility, and improves upon it by rejecting volatility as the measure of risk, using tail risk instead,” said Mr DePalma.
“We believe that TRP can help deliver balanced portfolios that cost-effectively reduce exposure to tail losses at times of market turbulence, and which can also participate in market upside during more normal conditions.”
AllianceBernstein developed this proprietary methodology with the help of Nobel Laureate Myron Scholes.
