Monday, March 14, 2011

Why Scary Announcements Are Great for Your Portfolio

By Larry Swedroe

One of the basic tenets of investing is that investors must be offered risk premiums to invest in riskier assets, as most investors are risk averse. The larger the risks, the greater the premium demanded. Thus, it would stand to reason that risk premiums should be even greater on days when stock markets are facing greater risk. Thanks to a recent study, we can see that this, indeed, appears to be true.

While some information about the economy arrives randomly over time, certain important macroeconomic news is released on regularly scheduled preannounced dates. While you may not have a crystal ball telling you what the news will be, you do know the announcement dates. Given the potential for surprises in the information, it would seem logical that the risk of investments will be higher around announcements — and investors will therefore demand a premium for taking increased risk. In other words, expected returns should be higher on announcement days.

The authors of the study “How Much Do Investors Care About Macroeconomic Risk?” studied the period from 1958 through 2009 and found that the evidence is consistent with economic theory. The following is a summary of their findings:

* On days when big news such as inflation, unemployment or interest rate numbers are announced, the average U.S. stock market returns and the Sharpe ratio are significantly higher.
* The average announcement day excess return is 0.11 percent versus 0.01 percent for all the other days — a figure statistically indistinguishable from zero.
* While announcement days make up just 13 percent of trading days, they account for more than 60 percent of the cumulative annual equity risk premium.
* Despite the significantly greater risk premium, the volatility of daily stock market returns is only 4 percent higher on announcement days.
* The Sharpe ratio is 10 times higher on announcement days.
* Even Treasury securities are affected by major announcements. Treasuries with maturities over one year behave similarly to the stock market, with higher excess returns, similar volatilities and significantly higher Sharpe ratios on announcement days.

As theory would suggest, the authors also found that the risk-free rate is lower on announcement days. The average holding period return on 30-day U.S. Treasury bills is 0.015 percent on announcement days, while it averages 0.017 percent on all days. Once again, the evidence is consistent with theory.

The authors concluded that “that the major component of the equity premium is compensation for exposure to news about the state of the economy: macroeconomic risk.” While this finding shouldn’t be surprising, what is surprising is both the magnitude of the risk premium on announcement days and the 10-fold improvement in the Sharpe ratio. The data seems to be telling us that investors have an incredibly high aversion (virtually implausible) to the risk of surprises in economic data.

The bottom line is that this study provides clear evidence that the winning strategy is to stop worrying about bad news coming on announcement days. This is especially true during bear markets — when investors fear and panic become prevalent emotions — when the already-large risk premium increases much more. And since any surprises will be incorporated into prices virtually instantaneously, you’re better off not “tuning in.” That will allow you to instead focus your attention on things that actually add value.

The next time you’re tempted to sell before the announcement of economic data — either because you fear a negative surprise or you were alarmed by an economist’s forecast — keep the evidence from this study in mind.

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