New related paper to #6 & #7 - Volatility Effect in Stocks and #20 - Volatility Risk Premium Effect Tuesday, 26 May, 2015

#6 - Volatility Effect in Stocks - Long-Short Version
#7 - Volatility Effect in Stocks - Long-Only Version
#20 - Volatility Risk Premium Effect

Authors: Ilmanen

Title: Do Financial Markets Reward Buying or Selling Insurance and Lottery Tickets?

Link: https://www.aqr.com/~/media/files/papers/faj-do-financial-markets-reward-buying-or-selling-insurance-and-lottery-tickets.pdf

Abstract:

Selling financial investments with insurance or lottery characteristics should earn positive longrun premiums if investors like positive skewness enough to overpay for these characteristics. The empirical evidence is unambiguous: Selling insurance and selling lottery tickets have delivered positive long-run rewards in a wide range of investment contexts. Conversely, buying financial catastrophe insurance and holding speculative lottery-like investments have delivered poor longrun rewards. Thus, bearing small risks is often well rewarded, bearing large risks not.

Notable quotations from the academic research paper:

...

"Buying insurance (limiting the left tail) and buying lottery tickets (enhancing the right tail) are popular activities both outside and within financial markets and thus tend to be “overpriced” compared with actuarially neutral prices. Conversely, selling insurance and selling lottery tickets may boost long-term returns.

Among recently popular strategies, these findings suggest that tail risk insurance can be a longrun money loser unless managers can pick their battles (i.e., are skilled in active timing and selection). These strategies may still serve a purpose as portfolio diversifiers because their rare gains tend to occur when they are most valuable to investors. Litterman (2011) argued that long-horizon investors should consider selling such insurance rather than buying it. Selling lottery tickets may be harder than selling insurance. Yet, various forms of low-volatility investing should benefit from underweighting or avoiding the most speculative, lottery-like investments within each asset class.

Finally, timing matters. Low-probability events are not always overweighted, and insurance is not always overpriced. New research suggests that only salient risks are overweighted. Recency is one simple indicator: Presumably, risks are more salient and risk premiums wider soon after adverse events, followed by a gradual fading of memories. After a long lull or when awash with liquidity, investors can be complacent with respect to particular risks and thus underweight them (either undervaluing them or underestimating their likelihood). Insurance-like strategies may be easier to time than strategies with symmetric distributions. Wide spreads and scarce capital after adverse events (e.g., recessions and financial crises) have often offered good entry levels for volatility-selling or carry-seeking strategies. Valuation-oriented timing/selection strategies are likely to serve investors better than, say, a blind “always sell insurance” approach. If tail risk insurance is bought, well-diversified and opportunistic approaches can be much cheaper than an option-based approach."


Are you looking for more strategies to read about? Check http://quantpedia.com/Screener

Do you want to see performance of trading systems we described? Check http://quantpedia.com/Chart/Performance

Do you want to know more about us? Check http://quantpedia.com/Home/About