Volatility: A story of stairs and elevators
Returns don't scale with risk indefinitely. Once the cost of leverage gets too high, returns falter. Investing becomes gambling. And that has a negative return.
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
TLDR Summary
More risk equals more expected return. Even though we often try to trick this principle in an effort to generate alpha, we all know it’s true. The entire finance industry operates based on this principle.
However, there is an important nuance to this law of finance. Expected returns do not really scale with volatility, at least not in a linear fashion as postulated by the capital asset pricing model (CAPM). Once the volatility of an asset reaches a certain threshold, expected returns falter. There are tons of assets serving as empirical evidence. The most extreme case is a lotto ticket with an expected return of near -100% and a volatility of near infinity.
Why is that the case? I believe that there is an adverse selection in the owners of an asset. The higher its volatility, the more investors are replaced by gamblers looking for a quick and big win. These gamblers are also more likely to employ leverage which exacerbates volatility. Sometimes, this leverage is explicit, sometimes it’s implicit, for example in open interest in call options.
As a result, I believe there are two types of assets: Stairs-up-elevator-down assets and elevator-up-stairs-down assets. I firmly believe that the expected return of the former exceeds the expected return of the latter, both in absolute and in risk-adjusted terms.