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Rethinking risk

Author

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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

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    4. 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.
    5. 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.
    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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