What are Fat Tails and why are they so powerful?

‘Fat tails’ is a statistical term that refers to greater-than-expected probabilities of extreme values, and is used within the financial markets industry. The term implies a strong influence of extreme observations on expected future risk.

To discover more about fat tails, continue reading our helpful guide below.

What are fat tails in finance?

In one respect or another, everyone will have come across the concept of a bell curve, whether it’s a distribution of height, intelligence, or any other metric with an upper and lower limit. As per the illustrations, the average is the most common and sits in the middle of the graph.

Fat tails are present in many of these typical distributions, but they’re often ignored or dismissed as anomalies.

The best way to visualise a fat tail is to imagine that the small segment on either side of the bell curve is a tail. Therefore, a fat tail is a distribution that is more one-sided than the symmetrical graph above.

Stocks and portfolios

Why is this at all relevant?

Imagine a portfolio of stocks. Most of the returns within the portfolio will be average when compared to their sector and geographical location.

Some of the companies may go out of business. At which point, their share price would reduce to zero. However, some will have the potential for massively outsized returns beyond any measure of a “normal” distribution curve.

At Acumen, we regularly talk about the companies that are unsuccessful being outweighed by those that continue to grow. This is definitely true and good long-term returns are often dependent on this very fact.

However, portfolio outperformance is almost always determined by “fat tails”. In other words, those companies that grow exponentially.

The dominance of MAMAA stocks

The S&P 500 (the index of 500 separate companies listed in the United States of America) is commonly used as an example of US markets as a whole.

According to Forbes, more than a fifth (22%) of the S&P 500’s entire index’s weighting is derived from just five companies: Meta (Facebook), Amazon, Microsoft, Apple and Alphabet (Google).

Somewhat incredibly, these five so-called “MAMAA” stocks have a combined market cap upwards of $10 trillion – compared with the S&P 500’s total market cap of roughly $44 trillion in March 2024.

The difficulty is, that no one can be sure which companies will provide the majority of future growth. If they could, they’d likely become very rich fairly easily.

If an investor selects a handful of individual companies that prove to be duds, then there is a real risk of losses.

Capturing the positive effects of fat tails

So, how can we capture the positive effects of fat tails, and at the same time ensure that their positive effects help balance the overall risk? The answer is diversification.

The last few years have shown us all that we don’t know what uncertainties will prevail within the stock market.

Diversification allows you to ignore the companies that don’t work, benefit from the “stalwart” steady growers, and enjoy the outsized performance of those positive fat tails.

This is why our investment philosophy at Acumen Financial Partnership has become pertinently focused on selecting the best Multi-Asset portfolios the market has to offer.

Investment advice from Acumen

At Acumen, we offer comprehensive, independent investment advice and planning, including asset allocation, appropriate investment selection, risk mitigation, inheritance tax mitigation, and educational cost planning.

Our investment advisers have the knowledge and experience to assess current investments and advise on future investments, providing an analytical, holistic and fully tailored approach to investment advice.

For investment advice from one of the leading Investment advice firms in the North West, contact us on 0151 520 4353 or email [email protected] to arrange a free consultation.

NB: This blog was first published on 10 August 2022 and has since been updated to provide the most accurate and up-to-date information available.