What makes a market ‘look risky’?

A couple of months ago, I wrote a post about research that examined what we look at when we look at price charts. In an independent study that could be considered a follow-up (at least when it comes to me writing a post), Xindi He and Yucheng Liang quantified some of these perceptions and showed how they influence our perception of the riskiness of an investment.

In a series of experiments with artificial stock price charts, they showed that investors’ assessment of the riskiness of an investment is driven to a large part by three factors: sign, clustering, and recency.

• Sign simply measures how often in the past the share price or index has gone up vs. gone down. You want this indicator to be as large as possible, indicating that the index has gone up more often than down.

• Clustering measures how much positive and negative returns are clustered together. The experiments show that if (positive and negative) returns are more bunched up in clusters, the investment is perceived as riskier. After all, if you invest at the wrong time, you may face an extended period of steeper and steeper losses. It’s just loss aversion in practice.

• Recency measures the obvious. The better the most recent returns of the investment, the more attractive it looks and the less risky it seems to be.

Below is a chart of a range of global stock market indices sorted from least volatile on the left to most volatile on the right, based on monthly data from 1990 to 2021. Traditional finance theory holds that volatility is a measure of how risky an investment is, but it takes one look at the subjective measures of risk to notice that volatility has absolutely nothing to do with how risky we perceive an investment to be.

Measures of riskiness of stock market indices

Source: He and Liang (2024)

I want to stick with a comparison of the relatively low risk FTSE 100 and the S&P 500 in the charts and ignore the Chinese and Russian indices to the right of the charts.

If we just look at index volatility, the FTSE 100 and S&P 500 look pretty much identical with very similar levels of volatility.

However, if we look at the subjective measures of risk there are some important differences. The chart on the top right shows that the ratio of positive to negative returns is significantly higher in the S&P 500 than in the FTSE 100, thus making the S&P 500 look much more attractive to investors.

The chart on the bottom left shows that when one invests in the S&P 500 at a random point in time, it is more likely to show a recent period of positive returns than the FTSE 100 and thus looks like a more promising investment to the casual investor who doesn’t follow the market daily.

Finally, the bottom right-hand chart shows that returns in the S&P 500 tend to be more clustered in streaks of up and down trends. This speaks against the S&P 500 and for the FTSE 100 because people tend to prefer more even advances. But of course, if you combine clustered returns with the recency effect and you imagine an investor who looks at the S&P 500 and sees a cluster of positive returns in the recent past, you know that this is going to make the S&P 500 look much more attractive than the FTSE 100.

In sum then, finance theory would say that the FTSE 100 and the S&P 500 are about equally risky. But from a subjective perspective, the S&P 500 looks like a more attractive investment by virtue of how the returns are generated over time.