There’s a growing body of evidence that risk is actually a double-edged sword.
Being risk averse, most investors assign more weight to what can go wrong during bad market periods than to the upside potential during good periods, when they pick stocks.
So, stocks that do poorly in bad times, such as in recessions or when there’s geopolitical storms brewing (Russia taking over Crimea), should carry what economists call large risk premiums. In other words, risky stocks tend to trade at lower prices and cheaper valuations than stable stocks do. And that’s what the research is showing.
Thierry Post, Pim Van Vliet and Simon Lansdorp, authors of the 2009 study “Sorting Out Downside Beta,” found that, from 1963 through 2009, risk was estimated to be 3.6 to 7.6 percent per year for downside beta, compared with 0.8 to 4.6 percent for regular beta.
The authors concluded: “When properly defined and estimated, [downside beta] is a driving force behind stock prices. Risk aversion thus not only helps to explain why stocks yield higher average returns than safer asset classes, but also why high-risk stocks yield higher average returns than low-risk stocks, ceteris paribus.”
Similarly, Joseph Chen, Andrew Ang and Yuhang Xing, authors of the 2006 study “Downside Risk,” found the downside risk premium to be about 6 percent per year. And it wasn’t simply compensation for regular market beta—nor was it explained by co-skewness or liquidity risk, or size, book-to-market, and momentum characteristics. The exception to their findings was that the highest-volatility stocks—about 4 percent of the market—had poor returns regardless of their exposure to downside risk. It seems to me the likely explanation is the well-known investor preference for “lottery tickets.”
A new study by Peter Xu and Rich Pettit, “No-Arbitrage Condition and Expected Returns When Assets have Different B’s in Up and Down Markets,” that appears in the February issue of the Journal of Asset Management, adds to the body of evidence on downside beta being an independent-priced risk.
They concluded that their model provides a useful perspective on what systematic risks are and how they are priced.
All of the evidence is consistent with the economic theory that investments that perform poorly in bad times should carry larger risk premiums. The higher return to stocks with high downside betas is compensation for accepting that risk.