NCPA - National Center for Policy Analysis

Greater Returns for Higher Risk

July 2, 2002

Stocks whose prices are highly correlated with market declines have higher expected returns than stocks that aren't highly correlated with market downturns. The difference between portfolios with the most downside risk and the least downside risk is very large, more than 6.5 percent per year, according to recent research. This shows there is a premium for holding stocks with a higher downside risk. Included in the findings:

  • Some of the profitability of the recently observed momentum effect (that stocks with high past returns continue to have high future expected returns) can be explained as compensation for bearing exposure to downside risk.
  • Downside risk means stocks that are more likely to decline when the market return is below its mean are less attractive.
  • In order for investors to hold these assets, the average return on these stocks must be higher (to compensate for their increased downside risk).

Source: "Higher Downside Risk Brings Greater Returns," NBER Digest, April 2002; based on Andrew Ang, Joseph Chen and Yuhang Xing, "Downside Risk and the Momentum Effect," NBER Working Paper No. 8643, December 2001, National Bureau of Economic Research.

For text

http://papers.nber.org/papers/W8643

 

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