{"id":130893,"date":"2022-06-30T06:40:56","date_gmt":"2022-06-30T10:40:56","guid":{"rendered":"https:\/\/44.250.171.167\/?p=130893"},"modified":"2023-04-25T08:48:02","modified_gmt":"2023-04-25T12:48:02","slug":"indias-self-delusion-towards-tail-risk-and-wealth-compunding","status":"publish","type":"post","link":"https:\/\/alphastreet.com\/india\/indias-self-delusion-towards-tail-risk-and-wealth-compunding\/","title":{"rendered":"India’s self delusion towards Tail Risk and Wealth Compounding"},"content":{"rendered":"\n

Before we delve into the topic, let me paint you a picture of the financial system.<\/p>\n\n\n\n

On 18th September 2007, Mr. Roy invested Rs. 1 lakh in NIFTY 50. He held it till 29th June 2022. His Rs 1 lakh had become around Rs 3.5 lakhs. He was happy about it but it got him thinking about all the stock market crashes he had witnessed in his 15 year journey. He decided to find out what if he had pulled all of his money before every crash (assuming days with 6% or more fall in a day). Out of about 3,500 days of active trading, only 15 such days were present. Mr. Roy thought what effect can 15 days make in 15 years in the market? Turns out that Rs. 1 lakh invested way back in 2007 would have become Rs. 10 Lakhs by now<\/em><\/strong>. Even in these crashes there are only three to four days of crashes that make most of the difference. The latest event being the coronavirus scare which led to a decline of 13% in one day. The effects are clearly visible in the graph below.<\/p>\n\n\n\n

\"\"<\/a><\/figure>\n\n\n\n



This is precisely how \u2018Left Tailed\u2019 events can tarnish your wealth compounding. This phenomena is so significant that left tailed events are not just to be remembered but they are essentially all that matters to the rate of compounding.<\/em><\/strong> The small losses or big or small gains are not nearly as important as the big losses or \u2018tail risks\u2019. <\/p>\n\n\n\n


<\/p>\n\n\n\n

‘Game of Probabilities’ starring Tail Risk<\/span><\/h3>\n\n\n\n

Coming to the definition, Tail Risk is a form of risk in which an investor\u2019s portfolio or the prices of assets move by more than three standard deviations. Modern Portfolio Theory and Black – Scholes formula base their theories and models on the assumptions that market returns follow a normal distribution which suggests that the probability of market returns beyond three standard deviations is 0.3%. The probability falls drastically as we go farther away from the mean. However, market returns do not reflect these characteristics. By that mathematics, a 13% drop\u2019s probability is almost negligible but it did happen. Here is the histogram of NIFTY 50 from 2007 to 2022. <\/p>\n\n\n\n

\"\"<\/a><\/figure>\n\n\n\n



So, every investor should be fixated on left-tailed events which hold the possibility of decimating our wealth by diminishing our Compound Annual Growth Rate (CAGR). The frequency and probability of their occurence have been grossly underestimated while their impact on an investor\u2019s CAGR is too significant to be underestimated.

<\/p>\n\n\n\n

Here\u2019s what Tail Risk Hedge Funds have done to tackle it:<\/span><\/h2>\n\n\n\n

They essentially place unusual bets that pay off if the markets crash. One of the most prevalent ways to do so is by purchasing out of the money \u2018Put\u2019 options consistently. While almost all of the trades fail, when the dreaded event occurs, they make great money out of that. <\/p>\n\n\n\n

Here is a rough structure of how a put option would do so:<\/p>\n\n\n\n

On 1st February 2020, Mr. Roy bought 75 units of NIFTY 50 put option at the price of Rs. 3 at the strike price of 9000 which expires on 26th March 2020. Keep in mind that NIFTY 50 was trading back then at 11,600. So, unless a major left-tailed event happens that makes the prices fall by 2,500 points in the course of a month, the options contract is worthless and Mr. Roy will lose all his Rs. 225. Then in mid March 2020, pandemic scare made the market crash and by 23rd March 2020, NIFTY is around 7610. Mr. Roy\u2019s out of the money put options are now very in the money and his Rs. 3 put options are now trading at Rs. 1441. Mr. Roy decided to sell his option for that price and his Rs. 225 bet became Rs. 1,08,075. Here is the Options Chain Data for that time:<\/p>\n\n\n\n

\"\"<\/a><\/figure>\n\n\n\n

Then Mr. Roy  takes this money and pours it back into the market. While his portfolio value had been battered by the crash, Mr. Roy offsets the loss with this gain.<\/p>\n\n\n\n

Now, there are two aspects that have to be considered:<\/p>\n\n\n\n

  • Mr. Roy purchases these Out of the Money put options every month and has been doing so for the last five years. He has spent and lost around (225*12*5) = Rs. 13,500. This hedge has diminished his compounding compared to a non-hedged portfolio. However, the inflow of Rs. 1,08,075 makes the trade worth considering for Mr. Roy.<\/li><\/ul>\n\n\n\n
    •   We also have to consider another dimension of this hedge. That is, its timing. The trade only provides returns when the market is down and automatically the best time to invest. <\/li><\/ul>\n\n\n\n

      * This example only portrays a rough structure of these trades. The example is not a true representation of reality. There are a lot of intricacies as well as risk involved in Options Trading. Derivatives markets should be properly understood before participating in it.<\/em><\/p>\n","protected":false},"excerpt":{"rendered":"

      Before we delve into the topic, let me paint you a picture of the financial system. On 18th September 2007, Mr. Roy invested Rs. 1 lakh in NIFTY 50. He held it till 29th June 2022. His Rs 1 lakh had become around Rs 3.5 lakhs. He was happy about it but it got him […]<\/p>\n","protected":false},"author":1885,"featured_media":130907,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"jetpack_post_was_ever_published":false,"footnotes":"","jetpack_publicize_message":"","jetpack_publicize_feature_enabled":true,"jetpack_social_post_already_shared":true,"jetpack_social_options":{"image_generator_settings":{"template":"highway","default_image_id":0,"font":"","enabled":false},"version":2}},"categories":[1941],"tags":[10076],"class_list":["post-130893","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-stock-analysis","tag-portfolio-risk-managment"],"jetpack_publicize_connections":[],"jetpack_featured_media_url":"https:\/\/alphastreet.com\/india\/wp-content\/uploads\/2022\/06\/Tail-Risk.png","jetpack_likes_enabled":false,"jetpack-related-posts":[{"id":135051,"url":"https:\/\/alphastreet.com\/india\/infographic-aptech-ltd-nse-aptecht-q1-results-total-revenue-57-94-cr-up-120-yoy\/","url_meta":{"origin":130893,"position":0},"title":"Infographic : Aptech Ltd (NSE : APTECHT) Q1 Results; Total Revenue = 57.94 Cr ( UP 120 % YoY)","author":"Divyansh_Kasana","date":"October 21, 2022","format":false,"excerpt":"Aptech started its education and training business in 1986 and has trained millions of students worldwide. 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