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Economic SYNOPSES 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 premium. Expected Sharpe Ratio Lettau and Ludvigson (2003) provide some 1.4 empirical evidence for this explanation. They use expected stock market volatility, which measures the size and frequency of fluctuations 0.7 in a broad stock market price index, as a gauge of stock market risk. When stock prices are 0 expected to be more volatile, risk-averse investors will reduce their stock holdings because the chance of having a large capital –0.7 loss becomes higher. Investors will hold the Mar-52 Mar-62 Mar-72 Mar-82 Mar-92 Mar-02 same amount of stocks as they did before only O Views expressed do not necessarily reflect official positions of the Federal Reserve System. research.stlouisfed.org