Tail Risks
Photo by SLNC on Unsplash
No, not that kind of tail. But it is a nice picture, is it not?
You know what's not a nice picture? Facing the future and all its uncertainties without a plan or protections in place. The well-known phrase of hope for the best but be prepared for the worst, does in fact have some wisdom to it. And so, let's talk about tail risks, and how we can be prepared for them.
Tail what?
You may be thinking: "What the heck is tail risk and what language is that and why are we discussing it?"
Tail risk is the risk that's associated with an extreme event that has a small probability of occurring.
(If you want to get bored quickly, read the next paragraph.)
Technically speaking, tail risk is called that because it refers to the extreme ends (the "tails") of a probability distribution curve, like a bell curve. These tails represent the less likely but potentially significant outcomes, often the worst or best-case scenarios, that lie outside the usual range of expected results.
(Okay, we're back!)
What does that have to do with financial planning? A lot.
In my mind, it's best if we have plans in place to protect us (to the extent we can) from these types of events. It's not that we can stop an extreme event from happening, but rather that we put ourselves in a better position for IF/WHEN it happens. We're trying to put things into place so that the tail risk doesn't ruin us, and most of the time we can make financial decisions ahead of time to help protect us in some way from the consequences of tail risks.
Like what?
Here are some examples:
Risk: Stock market crash and/or major recession
Protection: Splitting up our assets amongst Equities, Interest Earning assets, and Real Estate. Investment diversification. Not being overly aggressive with our investments. Generous cash position. (I'm sure this topic feels particularly relevant right now (as of May 2025); for more on this, check out my blog here.)
Risk: Getting sued
Protection: Insurance with high liability limits. Umbrella insurance. Business liability insurance.
Risk: Death
Protection: Life insurance. Wills, trusts, and other estate planning documents. Beneficiary designations.
Risk: Disability
Protection: Disability insurance. Health insurance. Uninsured/underinsured motorist liability coverage.
Risk: Bank failures
Protection: Staying within FDIC insurance limits.
Risk: Job loss
Protection: Generous cash position. Deep expertise in your field. Good professional network. High savings rate.
Risk: Natural and/or man-made disasters
Protection: Home/auto/earthquake/flood insurance. Emergency kits. Emergency plans. Generous cash position. Cybersecurity precautions (e.g., password managers, online backup, antivirus programs).
I'm sure there are plenty of other examples, but this gives you an idea of just a few tail risks and some brief ideas of how to protect ourselves from them. The bottom line is that we want to be prepared. We want to have protections in place so that if the worst happens, we will not be totally ruined.
Three sides of risk
Now, does this mean we need to buy every insurance product out there for everything we can think of? Of course not. I do not plan on having hurricane insurance while I live in Spokane, WA, if you catch my drift.
Generally speaking, there are three main sides of risk:
The odds you will get hit
The average consequences of getting hit
The tail-end consequences of getting hit
Let’s flesh this slightly silly example out a little more. The odds my family will be affected by a hurricane in Spokane, WA are very low, so even though the average and tail-end consequences of being affected by a hurricane are very high, the degree to which I protect myself against that kind of risk is less than perhaps I would against Fire Damage. Eastern WA is very commonly an area of high fire risk, and in fact, my wife's parents lost their family lake house only a few years ago.
It is so important to do an analysis of your current insurance coverage, estate documents, data backups, emergency fund, etc., and evaluate the odds of something happening vs. the consequences of something happening. We can prepare and protect.
A bit more about that 3rd side of risk
The third side of risk represents the really extreme events that are very unlikely but that can have disastrous consequences. These tail risks are the pandemics, the depressions, the major natural disasters, international war, etc.
Several years ago, we were going round and round in discussions about a few percentage points difference in interest rates, and then bam, a virus decimated our way of life for several years. Having things in place like a cash reserve, disability insurance, and a diversified portfolio are just a few things that can significantly help in the event of various events happening, including loss of life, job loss, disability, economic downturns, etc.
Whatever the risk may be, little or high chance of happening, and small or large consequences, let's do our best to not be caught without a plan or protections in place.
Of course, I hope these major events never happen to any of us. But the reality is, things happen, life happens, and inevitably there is loss in our lives.
If you're interested in listening to a good podcast regarding this topic, check out Taylor Schulte's thoughts on tail risk.