Expected Returns: An Investor's Guide to Harvesting Market Rewards

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Tail risks (volatility, correlation, skewness)

• Tail risks refer to volatility as well as other higher moments, such as correlation and skewness.

• The empirical relation between volatility and future returns is ambiguous.

• Selling equity index volatility and overweighting volatile asset classes appear to offer positive long-run rewards. However, stocks with the highest recent volatility tend to underperform other stocks. Also, among Treasuries and credit-risky bonds, the most volatile securities within the asset class have disappointingly low long-run returns. Over time, and contrary to intuition, higher market volatility does not predict higher near-term market returns.

• One explanation is that correlation risk is more consistently priced than volatility risk. This could explain the fact that for equity index options, implied volatility exceeds realized volatility most of the time, but the same is not true for single-stock options. In the same vein, and again contrary to intuition, high correlation across stocks is a bullish stock-market-timing indicator whereas high average volatility across stocks, or high market volatility, is not.

• There is some debate as to whether investors prefer positive or negative skewness. Market prices seem consistent with liking positive skewness or lottery seeking. Many indicators related to skewness and volatility suggest that the most lottery-ticket-like stocks are overpriced—their average near-term returns lag those of other stocks in a ...