Rethinking Risk

23 Pages Posted: 1 Sep 2013  

Javier Estrada

IESE Business School

Date Written: August 30, 2013

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 something 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% tail risks materialize, stocks offer long-term investors better downside protection than bonds in the form of a higher terminal wealth. In fact, stocks have both a higher upside potential and a more limited downside potential 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.

Keywords: Risk, volatility, tail risks, lower-tail terminal wealth

JEL Classification: G11, G12

Suggested Citation

Estrada, Javier, Rethinking Risk (August 30, 2013). Available at SSRN: https://ssrn.com/abstract=2318961 or http://dx.doi.org/10.2139/ssrn.2318961

Javier Estrada (Contact Author)

IESE Business School ( email )

IESE Business School
Av. Pearson 21
Barcelona, 08034
Spain
+34 93 253 4200 (Phone)
+34 93 253 4343 (Fax)

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