Downside risk matters once the lottery effect is controlled: explaining risk–return relationship in the Indian equity market

This study examines whether downside risk matters in the Indian equity market. We observe a strong negative relationship between standard variance-based risk measures (variance, beta, and idiosyncratic variance) and the expected stock returns. After controlling for traditional risk measures, analytically and statistically orthogonalized forms of downside risk measures present a positive risk–return relationship. In cross-sectional regressions, the downside beta shows a positive risk–return trade-off after controlling for the effect of traditional beta. It implies that investors avoid the “probability of loss” but look at the higher variance as a potential to earn higher returns. The desire to make speculative profits dominates over the need for safety while investing in the equity market. Investors seeking higher returns invest in high volatility or high beta stocks resulting in the overvaluation of these stocks. Preference for the lottery stocks (proxied by Max and idiosyncratic volatility) emerges as the strong determinant of cross-sectional variation of stock returns. After controlling for the lottery effect, the relationship between traditional beta and expected returns becomes flat.