Lower share prices mean high expected returns. This has long been one of the cornerstones of conventional financial economics. New research, though, shows that it is not true.
Yale University’s Stefano Giglio and colleagues surveyed American clients of Vanguard in February, when the S&P 500 was near a record high, and again in mid-March after it had fallen 20 per cent. They found that, after the fall, investors thought shares had become riskier: the probability they attached to shares falling more than 30 per cent in the following 12 months almost doubled from 4.5 to 8 per cent. Conventional financial economics says such greater risk should have been accompanied by higher expected returns. But it wasn’t. In fact, the opposite. In February, investors expected a 6 per cent return on the S&P 500 in the following 12 months, but in March they expected less than 2 per cent.
Lower prices and greater risk, then, led to lower expected returns – a flat contradiction of orthodox economics, and indeed common sense. Yes, shares have soared back since then; higher risk has led to higher returns. But lots of investors weren’t expecting this.