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How Disaster Risk Is Priced Into The Stock Market

How Disaster Risk Is Priced Into The Stock Market by [email protected]

In normal years, investing in equities can reap extremely healthy returns. But not all of that ROI is based on what you’d think. Some of it is rooted in the fear that everything could go terribly, unexpectedly wrong.

In this interview with [email protected], Wharton finance professor Jessica Wachter talks about her research into how the potential for major economic disasters impacts asset prices during times of apparent stability, and what that means for investors.

An edited transcript of the interview appears below.

A Hidden Reason for High ROI and High Volatility

My research links economy-wide disasters to asset prices, like stock prices, for example. This is research that I, along with others, have been pursuing recently — it’s really taken off over the last five years, and it has certainly gotten a boost from the financial crisis. Part of it draws on historical data about consumption disasters. An example of a consumption disaster is the Great Depression, where consumption fell by 20%. But that’s actually a relatively minor disaster. If you look at Europe after World War II, many countries had economies that contracted by as much as 50%.

If stock prices fall in the event of a disaster — and that is an important risk that investors take into account — that can explain why in normal times we have such high returns on stock prices, which has long been a puzzle. It can also explain why stock prices are so volatile, because this risk is hard to calculate, and as investor’s perceptions of it move around, that can move around stock prices.

“One of the reasons that stock returns are so volatile is because of these fears of a disaster.”

Key Takeaways

The first takeaway is that there are these risks for consumption disasters, and they are reflected in stock prices, which is why we see such a high realized return during normal times when we don’t have disasters. Also, one of the reasons that stock returns are so volatile is because of these fears of a disaster. Now, you might think of these fears as overreactions, because often the disaster doesn’t happen. However, is it overreaction or do people really have a reason to be afraid? Certainly, in 2008, it seemed like we had a reason to be afraid.

Surprising Findings

Stock market volatility has been a puzzle for a long time. What surprised me is that when we put this international data from disasters into a model, we found it really could explain the magnitudes of stock market volatility that we see. Part of it is investors’ risk aversion. When you have even a small probability of a 50% decline or even a 20% decline, it really influences investors’ behavior.

“When you have even a small probability of a 50% decline or even a 20% decline, that really influences investors’ behavior.”

A Fundamental Misunderstanding about Returns

Unfortunately, I think some people have a wishful thinking view of the stock market — that if you just hold on long enough, you’re guaranteed to get some of the high rates of return that we’ve measured over the post-[World War II] period, these rates of return being 12%. Well, that may not be true. Now, this is not a suggestion that investors shouldn’t hold stocks. I hold stocks and I think for investors who have positive net worths, stocks are an important part of the portfolio, but in evaluating the risk, they could go down and they might not come back up.

See full transcript here.

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How Disaster Risk Is Priced Into The Stock Market
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