What are two ways to manage tail risk in an investment portfolio?

Managing tail risk involves mitigating the potential for significant losses that can occur in extreme market conditions. The correct approach involves both diversification and targeted hedging strategies.

Portfolio diversification ensures that an investment is spread across various assets or asset classes, which can reduce the overall risk. By diversifying, the impact of a poor-performing asset can be lessened by the performance of other, more stable investments. This can help to reduce the overall volatility of the portfolio, making it less susceptible to extreme market movements.

Tail risk hedging through put options allows an investor to purchase the right to sell an asset at a predetermined price, providing protection against significant drops in asset value. If the market experiences a drastic downturn, these put options can be exercised, offsetting losses from other investments. This proactive approach is crucial for managing tail risk because it specifically targets the protection against extreme negative outcomes.

Combining these two strategies offers a robust framework for managing tail risk, making them the most effective means in this context. The other options either imply increased risk-taking or do not sufficiently address the characteristics of tail risk management.