Volatility Lessons

The average monthly premium of the Market return over the one-month T-bill return is substantial, as are average premiums of value and small stocks over Market. As the return horizon increases, premium distributions become more disperse, but they move to the right (toward higher values) faster than they become more disperse. There is, however, some bad news. Even if future expected premiums match high past averages, high volatility means that for the 3- and 5-year periods commonly used to evaluate asset allocations, the probabilities of negative realized premiums are substantial, and the probabilities are nontrivial for 10- and 20-year periods.A practitioner's perspective on this article is provided in the In Practice piece "Volatility: It's Worse Than You Thought " by Phil Davis, online 6 August 2018. Disclosure: The authors are consultants to, board members of, and shareholders in Dimensional Fund Advisors. Editor’s Note This article was externally reviewed using our double-blind peer-review process. When the article was accepted for publication, the authors thanked the reviewers in their acknowledgments. Lisa Goldberg was one of the reviewers for this article. Submitted 30 November 2017 Accepted 25 April 2018 by Stephen J. Brown