Did Two Professors Finally Solve the 20-year-old Volatility Puzzle?
The most basic concept in finance is that higher risk equals higher returns.
However, when it comes to risky stocks (stocks with higher volatility), decades of research shows the opposite. Over time you don’t get paid extra by putting your money in risky stocks.
Solving a Famous Puzzle
Experts call this the “idiosyncratic volatility puzzle”. This is framed as a puzzle because shouldn’t higher risk and higher returns go hand in hand? So why is it you consistently make less money by taking on more risk when they teach you the opposite in finance?
Two finance professors, Junxiong Gao and Jun Liu, wrote a 71-page paper that basically says: “Wait a minute, I think we know the answer to the puzzle.”
Gao and Liu’s explanation:
The puzzle happens because small companies tend to be way more volatile than big companies. When you sort stocks purely by volatility, you accidentally end up with a bunch of tiny, risky companies that underperform.
Their fix: Instead of just looking at volatility, look at size-adjusted volatility (basically volatility times market share). When you do this, the relationship starts making sense: higher risk does mean higher returns, just like it should.
When they account for size properly, about 80% of the “volatility puzzle” disappears.
What Should Investors Do With This Information?
For most people, buying small volatile stocks is unnecessary gambling, but buying large volatile stocks could pay off. The phrase “higher risk, higher reward” does hold up for mega-cap stocks.
Overall, Gao and Liu offer a math-based rethink of risk in our markets, emphasizing that size matters as much as volatility.