It has long been known that investors have asymmetric preferences when it comes to bearing downside risk versus participating in the upside.
The term “loss aversion” refers to an investor’s tendency to prefer avoiding losses more strongly than acquiring gains. Most studies suggest a loss is twice as powerful, psychologically, as an equal-sized gain. This aversion helps explain why the equity risk premium has been so large; the risk of owning equities is highly correlated with the risks of the economic cycle.
Thus, in recessions, investors who earn wages or own businesses are exposed to the double whammy of bear markets and either job layoffs or reduced business income (or even bankruptcy).
Because investors are, on average, highly risk averse, it should be no surprise they have demanded a large equity premium as compensation for accepting the risks of this double whammy, especially when considering that the risk of unemployment or the loss of business income are basically uninsurable. Investors might be forced to sell stocks (because of the diminution of earned income) at the worst possible time.
A Study On Accepting Risk
Roni Israelov, Lars Nielsen and Daniel Villalon contribute to the literature on investors’ asymmetric preference for risk with their paper “Embracing Downside Risk,” which appears in the Winter 2017 issue of The Journal of Alternative Investments.
Using equity index options prices, they showed that the vast majority of the equity risk premium derives from accepting downside risk versus seeking participation in the upside. They found that, over the period 1986 through 2014, greater than 80% of the equity risk premium was explained by the willingness to accept downside risk.
The conclusion we can draw is that investors who seek to maximize upside potential while minimizing downside risk through options (buying call and put options) are highly likely to underperform due to the cost of that insurance, the size of which is related to the asymmetric preference for risk.
In other words, demand for upside participation is strong, while the tolerance for accepting downside risk is weak. The result is that the volatilities implied in the options tend to be greater than realized volatility. In fact, Israelov, Nielsen and Villalon found that the ex-post variance risk premium (VRP) was positive 88% of the time and averaged 3.4% per year.
Behavioral finance provides us with an explanation for this phenomenon. Investors have a preference for the positive skewness (meaning there is the potential for large gains) offered by buying puts, and they dislike the negative skewness (meaning there is the potential for large losses) that results in selling puts.
Israelov, Nielsen and Villalon found a similar result when they examined the upside and downside risk premium in Treasury bonds, with 62% of the excess return coming from the downside.
The lower percentage they found in bonds shouldn’t be surprising, because Treasuries have less downside risk than stocks. When they examined gold, the authors found 100% of the excess return was from downside risk.
They also found very strong results when they looked at credit default swaps, with the return for accepting downside risk accounting for more than 100% of the excess return. However, they note this result could be heavily influenced by the recent financial crisis, as the data only covered the period July 2007 through June 2015.
These findings are consistent with other research on the VRP.