Bear Beta or Speculative Beta?—Reconciling the Evidence on Downside Risk Premium
Review of Finance, Volume 27, Issue 1, February 2023, Pages Pages 325–367, https://doi.org/10.1093/rof/rfac006
Our research shows that the most fundamental principle in investments fails when it comes to managing bear market risk exposure of your stock portfolio. Investors have long been taught that the reward they earn in the form of expected return is proportional to the amount of risk they are willing to take. If you take on more risk, you can expect to earn a higher return, right?
We find that stocks that bear the most bear market risk, i.e., those that perform particularly poorly during market downturns, also tend to earn the lowest expected returns. By avoiding them, investors can reduce their portfolio risk and improve then portfolio return at the same time!
The main peril of constructing portfolios to hedge bear market risk suggested by previous research lies in the reliance on the historical performance of stocks during bear markets. It was assumed that stocks that performed well during the past bear markets must be good hedges against future bear markets. Our research indicates that the reality is the opposite: Stocks that looked like good hedges in the past tend to perform very poorly during future downturns. Holding such stocks would increase your exposure to the bear market risk and negatively impact your average portfolio return. So, investors should avoid such stocks at all cost.