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short essays and reports on the economic issues of the day
2006 ■ Number 23

Are Investors More Risk-Averse During Recessions?
Hui Guo
bservers of financial markets have long noted that
if they are compensated by a higher equity premium. Thus,
broad stock market price indices tend to fall steeply
one can use the ratio of the expected equity premium to
immediately before and during recessions. In theory,
the expected volatility—which is commonly known as the
a stock’s price is equal to the sum of its discounted expected
Sharpe ratio—as a measure of shareholders’ risk tolerance.
future dividends, and the discount rate is the expected gross
For example, for a given level of expected stock market
stock return. Thus, it is tempting to suggest that, when the
volatility, investors require a higher equity premium and
economy becomes weaker, the sharp decrease in stock
thus a higher Sharpe ratio if they become more risk-averse.
prices reflects the reduction in expected future dividends.
In the accompanying chart, we replicate Figure 3 of
However, many studies have found that the magnitude of
Lettau and Ludvigson (2003) using updated data from
the cyclical fluctuation in dividends is too small to account
1952:Q2–2004:Q4. The shaded area indicates business recesfor such large stock market price movements.
sions dated by the National Bureau of Economic Research.
One possible explanation is that large changes in stock
We find that the Sharpe ratio exhibits substantial variation
prices might be accompanied by swings in investors’ attitude
across time. More importantly, it increases dramatically just
toward risk. For example, many commentators have roubefore and during every recession in the 52-year sample.
tinely suggested that investors exhibited irrational exuberThis pattern appears to be consistent with the conjecture
ance during the dramatic stock price run-up in the late
that investors are more risk-averse and thus demand a higher
1990s, while they were overly pessimistic during the Great
return for holding stocks during economic downturns. ■
Depression in the early 1930s. Campbell and Cochrane
Campbell, John Y. and Cochrane, John H. “By Force of Habit: A Consumption(1999) have formalized the idea in a model: When the econBased Explanation of Aggregate Stock Market Behavior.” Journal of Political
omy goes into recession, investors have fewer resources to
Economy, 1999, 107, pp. 205-51.
maintain their accustomed living standards and thus are
Lettau, Martin and Ludvigson, Sydney. “Measuring and Modeling Variation in
the Risk-Return Tradeoff.” Unpublished manuscript, New York University, 2003
less willing to bear financial risk. To induce them to hold
(forthcoming in Handbook of Financial Econometrics, edited by Yacine Ait-Shalia
stocks instead of risk-free short-term Treasury bills, for a
and Lars Peter Hansen).
given level of stock market risk, the expected equity pre1 The equity premium is the difference between the stock market return and the
mium must increase.1 Therefore, stock prices fall during
risk-free rate.
recessions because dividends are discounted by a higher
rate as a result of the increase in the equity
Expected Sharpe Ratio
Lettau and Ludvigson (2003) provide some
empirical evidence for this explanation. They
use expected stock market volatility, which
measures the size and frequency of fluctuations
in a broad stock market price index, as a gauge
of stock market risk. When stock prices are
expected to be more volatile, risk-averse
investors will reduce their stock holdings
because the chance of having a large capital
loss becomes higher. Investors will hold the
same amount of stocks as they did before only


Views expressed do not necessarily reflect official positions of the Federal Reserve System.