Risk Neglect in Equity Markets

Abstract

The link between measures of risk and return within the equity market has been very weak over the past 47 years. In the United States, returns on high-risk stocks have cumulatively fallen short of returns on low-risk stocks during a period when the equity market as a whole experienced high returns relative to Treasury bills. The author takes seriously the idea that this evidence reflects a risk anomaly—a mispricing of risk for behavioral and institutional reasons—and revisits the associated implications for investing and corporate finance. The author examines asset allocation, high leverage in financial firms, and low leverage in industrial firms, as well as private equity, venture capital, and bank capital regulation along the way.