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Expectations of risk and return among household investors: Are their Sharpe ratios countercyclical?

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Abstract

Data obtained from special questions on the Michigan Survey of Consumer Attitudes are used to analyze stock market beliefs and portfolio choices of household investors. We find that expected risk and return are strongly influenced by economic prospects. When investors believe macroeconomic conditions are more expansionary, they tend to expect both higher returns and lower volatility. This implies that household Sharpe ratios are procyclical, which is inconsistent with the view that stock market returns should compensate investors for exposure to macroeconomic risks. The finding of procyclical expected returns holds up when we instead condition on conventional business cycle proxies such as the dividend yield and the consumption-wealth ratio. We further find that perceived risk in equity returns (though not the expected returns themselves) is strongly influenced by household investor characteristics, consistent with documented behavioral biases. The relevance of investor expectations is supported by the finding that the proportion of equity holdings in respondent portfolios tends to be higher for those who report higher expected returns and lower uncertainty.

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  • Gene Amromin & Steven A. Sharpe, 2009. "Expectations of risk and return among household investors: Are their Sharpe ratios countercyclical?," Proceedings, Federal Reserve Bank of San Francisco, issue Jan.
  • Handle: RePEc:fip:fedfpr:y:2009:i:jan:x:1
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    3. Broer, Tobias & Kero, Afroditi, 2021. "Collateralization and asset price bubbles when investors disagree about risk," Journal of Banking & Finance, Elsevier, vol. 128(C).
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    6. Dittmann, Ingolf & Montone, Maurizio & Zhu, Yuhao, 2023. "Wage gap and stock returns: Do investors dislike pay inequality?," Journal of Corporate Finance, Elsevier, vol. 78(C).
    7. James Crotty, 2009. "Structural causes of the global financial crisis: a critical assessment of the 'new financial architecture'," Cambridge Journal of Economics, Cambridge Political Economy Society, vol. 33(4), pages 563-580, July.
    8. Basit Zafar & Theresa Kuchler, 2015. "Expectation Formation," 2015 Meeting Papers 678, Society for Economic Dynamics.
    9. Merkle, Christoph & Weber, Martin, 2014. "Do investors put their money where their mouth is? Stock market expectations and investing behavior," Journal of Banking & Finance, Elsevier, vol. 46(C), pages 372-386.
    10. Jacobsen, Ben & Lee, John B. & Marquering, Wessel & Zhang, Cherry Y., 2014. "Gender differences in optimism and asset allocation," Journal of Economic Behavior & Organization, Elsevier, vol. 107(PB), pages 630-651.
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