Can uncertainty be a good thing for investors?
Risk benchmarks need both positive and negative considerations
This article is reprinted from Knowledge@Wharton, the online business analysis journal of the Wharton School of the University of Pennsylvania, which holds the copyright to this content.
You don't have to be involved in investing very long to know that, as the pros say: "The markets hate uncertainty."
It's easy to understand why markets are roiled by catastrophic events such as the collapse of Lehman Brothers in 2008, which was the kickoff of the global financial crisis. In such scenarios, stock prices fall, investors rush to safe havens and drive down bond yields, and typically the real economy is shaken.
So, the common view of uncertainty – or volatility, as it is often termed – is that it is bad, period. "Investors don't like this kind of uncertainty," says Amir Yaron, a professor of finance at Wharton.
But new work by Yaron, Wharton finance professor Ivan Shaliastovich and PhD candidate Gill Segal zooms in on the process and reveals that, in key respects, the net effects of uncertainty are greater than previously thought, and also that they are not always bad.
In fact, uncertainty related to good events is typically followed by desirable results such as greater economic growth, higher investment rates and higher asset prices. The research is described in the paper, Good and Bad Uncertainty: Macroeconomic and Financial Market Implications.
In the past, Yaron says, research has generally not distinguished between good and bad surprises. In that traditional view, uncertainty has been seen as one force, a deviation from the norm that upsets everyone's expectations.
When good surprises, such as the tech revolution of the 1990s, are lumped in with bad ones, such as the Lehman collapse, negative and positive events largely cancel each other out over time, softening the apparent effect of uncertainty in general.
"What you are getting is a muted response," Yaron says. "You are not getting the full effect of uncertainty." As a result, investors could underestimate the effect of a surprise, failing to bail out over bad news or to raise one's bet after a positive surprise.
Uncertainty related to good events is typically followed by desirable results such as greater economic growth, higher investment rates and higher asset prices.
To assess the effects of positive and negative surprises, the researchers used a novel approach of semi-variances (a statistical measure of risk) to identify shocks to good and bad uncertainty and volatility in industrial production growth data from 1930 to 2012.
They then showed that these volatility shocks have significant and opposite effects on measures of consumption, output, investment, research and development, investment returns and dividends.
"For example," they write, a measure of private GDP which excludes government purchases "increases by about 2.5% one year after a one standard deviation shock to good uncertainty, and this positive effect persists over the next three years. On the other hand, bad uncertainty shocks decrease output growth by about 1.3% one year after, and their effects remain negative for several years."
The traditional view, lumping all uncertainty together, disguises these effects because the good and bad results largely offset one another, suggesting, for example, that uncertainty reduces GDP growth by a mere 0.25%.
"The response to total uncertainty is significantly weaker than that to bad uncertainty, which underscores the potential importance of decomposing uncertainty into good and bad components," the researchers write.
Another key message from the paper: Overall, negative shocks do more harm than positive shocks do good.
"When good uncertainty doubles from its average value, expectations of next-year aggregate consumption increase by 0.2%," Shaliastovich says. "When bad uncertainty doubles, one-year expected consumption growth declines by almost 0.7%."
The effects of shocks are seen in corporate strategy as well. Corporate investment and research and development "significantly increase with good uncertainty and remain positive five years out, while they significantly drop with a shock [of] bad uncertainty".
As one would expect, shocks also affect asset prices such as stocks and bonds. With good uncertainty, for instance, the price-dividend ratio, a commonly used valuation ratio in finance, rises, and the effect persists for a decade.
A bad shock has the opposite effect, also lasting for 10 years. Because they offset one another, these effects are less pronounced when good and bad shocks are lumped together.
Seeing uncertainty in its two forms, good and bad, can help investors better determine whether a potential investment promises a return high enough to compensate for the risk
Using a variety of investment portfolios, the researchers found that while good shocks improve performance and bad shocks make it worse, both types of shocks raise risk premiums, or the extra compensation investors demand when they think risks are greater.
Seeing uncertainty in its two forms, good and bad, Yaron explains, can help investors better determine whether a potential investment promises a return high enough to compensate for the risk. The potential effect of good and bad surprises must be distinguished, according to the authors.
"When investors make bets and think of a certain investment as providing an extra return, that extra return is always with respect to some perceived benchmark of risk," Yaron says. "And what we are saying is that benchmark of risk has to have these two perspectives."