Upside risk is not risk, except…

Everybody with half a brain knows that when modern portfolio uses volatility (or variance) as a measure of risk, this isn’t really risk. A stock might have significant volatility, yet if it is going up all the time, investors won’t care too much about that volatility. And on the other hand, if share prices go down, the volatility can be low, and investors will still be concerned.

Juan Londono from the Federal Reserve has recently shown nicely, how the equity risk premium can be split up into upside risk and downside risk premia. And he found that the correlation between downside risk and the equity risk premium in the market is 0.97. Meanwhile, the correlation between upside risk and the equity risk premium is 0.26. So, downside risk is what explains risk premia almost all the time.

But wait, why is the correlation between upside risk and the equity risk premium 0.26? If investors don’t care about upside risks, shouldn’t the correlation be zero? Is this just a spurious correlation or is there more to the story? The chart below shows the size of the downside risk and upside risk measure for the S&P 500 between 1991 and 2019. And it is immediately clear the correlation between upside risk and the equity risk premium is not just accidentally 0.26. There is a systematic effect.

Upside and downside risks in the S&P 500

Source: Londono (2021)

The upside risk component of the equity risk premium becomes negative every time we see an extreme spike in downside risks. The LTCM crash in 1998, the 9/11 attacks, the Lehman Brothers collapse in 2008 and the near default of the US in August 2011 are clearly visible. During these episodes of market panic investors simply don’t care about upside moves.

But note that shortly after these extreme negative spikes in upside risks upside risk premia increase and become higher than average. There is a brief period of extended upside risk premia. This is the period at the height of a crisis or a recession when most investors are bearish and hedge funds likely have entered material short positions on the market. And once investors have positioned themselves for a continued decline in markets, upside risks become material. Because if a hedge fund gets caught in a short position when the market recovers, it will start to lose money, and quickly.

This can explain why market snapbacks at the end of a recession can be so dynamic. The old Wall Street adage is that markets go up on an escalator and down in a lift. That is true. Bull markets tend to be long and steady, while bear markets are fast and furious. But once investors have come to terms with a bear market, the situation flips and what used to be downside risk becomes upside risks and vice versa. In these situations, markets do indeed go down on an escalator and up on an elevator for a short period of time.