The Low Downside Risk Effect - Lower Risk and Higher Returns with Low Downside Risk

Abstract

Past downside risk is shown to have an even stronger influence on future stock sector performance than past low risk as represented by traditional risk parameters that represent both down- and upside risk in one single measure.The fact past low (downside) risk stocks outperform past high risk stocks in the future (or the fact past high risk stocks don’t outperform past low risk stocks), is usually seen as an anomaly to be explained by many sources of biased investor preferences for high risk stocks. As is pointed out in this paper, the outperformance of low over high risk stocks isn't an anomaly and can not be explained by biased investor preferences for risky stocks. Instead, I suggest an opposite view: in line with basic micro economics, financial economics and behavioral finance principles the market values highest and trades accordingly what it likes most: low risk. And even more so: low downside risk. Vice versa, I suggest the market values lowest and trades accordingly what it dislikes most: high risk and particularly high downside risk.