High Risk, No Reward

30 January 2018  |  Professor Stefan Mittnik, PhD
High risk No fun
A 100-year chart of the Dow Jones shows that when volatility soars, it's time to sell equities.
Sticking to this rule of thumb improves an investor’s chances to cushion the impact of stock market crashes.

No risk, no reward - you know the saying. However, if you’re referring to investing in the stock markets, you may want to re-think that concept. This chart shows how the Dow Jones and its risk - measured in terms of volatility - has developed over more than 100 years.

When Risk Isn’t Rewarded

Dow Jones Index (in points) and volatility* (in%)

Dow Jones Index over 100 years  (in points) and volatility (in%)

* From 1918 to 2017, logarithmic representation; Source: Samuel H. Williamson "Daily Closing Value of the Dow Jones Average 1885 to Present" - Measuring Worth 2018, own calculations; Note: Neither past performance nor forecasts are reliable indicators for future performance.

Even a quick glance at the chart reveals that if volatility (measured here for illustration, as the standard deviation of the daily returns of the past 200 trading days) jumps to over 20 per cent, this increase in risk is usually accompanied by falling prices or at least below-average performance. Prices typically only recover once volatility falls back to average levels. High risk, less reward - is more apt for this chart. It therefore comes as no surprise that the Dow Jones is currently rewarding investors handsomely, given that its volatility is at a 50-year low.

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The good news about the above observation is this: The risk-return relationship can be put to good use. At Scalable Capital, we factor it into our investment model. You can read more about how we do this in our article “How does dynamic risk management work?”.

Make no mistake, none of this means that the risks associated with investing in the stock markets are not rewarded. In fact quite the opposite, those who invest in asset classes with a higher average risk profile can typically expect to earn higher returns in the long term. Equities, for example, simply deliver higher returns than bonds over a longer investment horizon, despite being more volatile in the short-term. My point is: it does not pay to take excessive risks and be exposed to an asset class during times of above-average volatility. Instead, if risk increases to levels far beyond the historical average, meager or even negative returns are to be expected. Savvy investors should reduce their exposure during those times.

Image: Unsplash.com/JC Dela Cuesta

Risk Warning – With investment comes risk. The value of your investment can go down as well as up and you may get back less than you invest. Past performance or future projections are not indicative of future performance. We do not provide any investment, legal and/or tax advice. If this website contains information regarding capital markets, financial instruments and/or other topics relevant for investments of assets, the exclusive purpose of this information is to give general guidance on investment management services provided by members of our group. Please note our Risk Warning and the Website Terms.

 

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Stefan Mittnik
Professor Stefan Mittnik, PhD
CO-FOUNDER & ADVISOR
Stefan is Professor of Financial Econometrics and Director of the Centre for Quantitative Risk Analysis at the Ludwig Maximilians University in Munich. He served on the Research Advisory Board of the Deutsche Bundesbank and was research director at the CFS and the Institute for Economic Research in Munich. He has spent about 30 years researching, analysing, modelling and forecasting financial risk.