Rethinking Risk

Volatility is the most widely-used measure of risk but its relevance is questionable in many settings. For long-term investors, short-term volatility is something they just have to live with and disregard as much as possible. Tail risks, however, are critical because, although rare by definition, they have a large impact on terminal wealth. Using a comprehensive sample that spans over 19 countries and 110 years, this article argues that when 1%, 5%, or 10% tail risks materialize, stocks offer long-term investors better downside protection than bonds in the form of a higher terminal wealth. In fact, stocks have both a higher upside potential and a more limited downside potential than bonds, even when tail risks strike. Hence, their higher volatility essentially is higher upside risk; that is, uncertainty about how much better, not how much worse, long-term investors are expected to fare with stocks rather than with bonds