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Rethinking risk

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  • Javier Estrada

    (IESE Business School)

Abstract

Volatility is the most widely used measure of risk but its relevance is questionable in many settings. For long-term investors, short-term volatility is a nuisance they just have to live with and disregard as much as possible. Tail risks, however, are critical because, although rare by definition, they have a large impact on terminal wealth. Using a comprehensive sample that spans over 19 countries and 110 years, this article argues that when 1, 5 or 10 per cent tail risks strike, stocks offer long-term investors better downside protection than bonds in the form of a higher terminal wealth. In fact, stocks offer both a higher upside potential and better downside protection than bonds, even when tail risks strike. Hence, their higher volatility essentially is higher upside risk; that is, uncertainty about how much better, not how much worse, long-term investors are expected to fare with stocks rather than with bonds.

Suggested Citation

  • Javier Estrada, 2014. "Rethinking risk," Journal of Asset Management, Palgrave Macmillan, vol. 15(4), pages 239-259, August.
    • Handle: RePEc:pal:assmgt:v:15:y:2014:i:4:d:10.1057_jam.2014.21
    DOI: 10.1057/jam.2014.21
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    References listed on IDEAS

    as
    1. Javier Estrada, 2013. "Are stocks riskier than bonds? Not if you assess risk like Warren Buffett," Journal of Asset Management, Palgrave Macmillan, vol. 14(2), pages 73-78, April.
    2. Tim Bollerslev & Viktor Todorov, 2011. "Tails, Fears, and Risk Premia," Journal of Finance, American Finance Association, vol. 66(6), pages 2165-2211, December.
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    4. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
    5. Robert J. Barro, 2009. "Rare Disasters, Asset Prices, and Welfare Costs," American Economic Review, American Economic Association, vol. 99(1), pages 243-264, March.
    6. Javier Estrada, 2009. "The Gain‐Loss Spread: A New and Intuitive Measure of Risk," Journal of Applied Corporate Finance, Morgan Stanley, vol. 21(4), pages 104-114, September.
    Full references (including those not matched with items on IDEAS)

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