THE IMPACT OF TAIL RISK AND BLACK SWAN EVENTS ON MODERN PORTFOLIO THEORY. A REASSESSMENT OF RISK ASSUMPTIONS IN EXTREME MARKET CONDITIONS
THE IMPACT OF TAIL RISK AND BLACK SWAN EVENTS ON MODERN PORTFOLIO THEORY. A REASSESSMENT OF RISK ASSUMPTIONS IN EXTREME MARKET CONDITIONS

Summary/Abstract: The unpredictability of financial markets, underscored by the occurrence of tail risks and Black Swan events, has exposed critical weaknesses in the foundational assumptions of Modern Portfolio Theory (MPT). MPT's reliance on normal distribution models and the Efficient Frontier framework often leads to underestimation of the probability and impact of rare, catastrophic events, thereby offering a false sense of security in portfolio risk management. This paper reexamines these core assumptions, emphasizing the need to incorporate non-normal distributions and fat-tailed risk into contemporary portfolio construction. Drawing from both theoretical critiques and empirical data, this study investigates the frequency, magnitude, and economic fallout of extreme market events such as the 2008 Financial Crisis and the COVID-19 market shock. It assesses how these events challenge the traditional risk-return tradeoff, revealing that traditional diversification strategies, based on correlation assumptions, fail to protect portfolios during systemic market failures. In response, this paper proposes the integration of advanced risk management frameworks, such as stress testing, scenario analysis, and tail hedging techniques, to enhance portfolio resilience. Furthermore, the research delves into behavioral finance and its role in exacerbating market instability during extreme conditions, questioning how investor psychology impacts risk assessments during Black Swan events. Through a comprehensive reassessment of risk management strategies, this study advocates for a new paradigm that blends modern quantitative methods with a qualitative understanding of market dynamics, ultimately fostering a more resilient approach to portfolio management in an era of uncertainty.

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