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So my research links economywide disasters to asset prices like stock prices for example. Um this is research
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that I along with others have been pursuing recently say it's it's really
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um taken off over the last five years and it's certainly gotten a boost from
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the financial crisis. uh and in this research um part of it draws on historical data on consumption
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disasters from the United States and from elsewhere in the world. An example of a consumption disaster is the Great
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Depression where consumption fell by 20%. Um but that's actually a relatively
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minor disaster. If you look at Europe, um after the Second World War, many countries had economies that contracted
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by as much as 50%. Um if stock prices fall in the event of a disaster then that is an important risk that investors
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take into account and that can explain why in normal times we have such high returns on stock prices which has long
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been a puzzle. It can also explain why stock prices are so volatile because this risk is hard to calculate and very
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hard to measure and as investors perceptions of it move around that can move around stock prices.
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So the first takeaway is that the world is risky that there are there are these risks for consumption disasters and they
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are that's reflected in stock prices and that's why we see such a high realized
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return during normal times when we don't have disasters. Also one of the reasons that
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stock returns are so volatile is because of these fears of a disaster. Now, you might think of these fears as
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overreaction because often the disaster doesn't happen. However, is it overreaction or do people really have a
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reason to be afraid? Certainly, in 2008, it seemed like we had a reason to be afraid. Well, stock market volatility
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has been a puzzle for a long time. So what surprised me is that when we put the um information this international
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data from disasters into a model that this really could explain the magnitudes of stock market volatility that we see.
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Part of it is investors risk aversion. So when you have numbers like even a small probability of a 50% decline or
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even a 20% decline that really influences investors behavior. Unfortunately, I think some people have
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a wishful thinking view of the stock market that if you just hold on long enough that you're guaranteed to get
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some of the high rates of return that we've measured over the post-war period,
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these rates of return being 12% that this is just something you're going to get if you keep holding stocks. Well,
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that may not be true. Now this is not a measure that investors shouldn't hold
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stocks. I I hold stocks and I think for investors who have positive net worth stocks are an important part of the
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portfolio. But in evaluating the risk they could go down and they might not come back
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up. So one of them is for investors that investors should be aware that stocks are risky um that and that the return is
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not guaranteed. What this means um is not that you shouldn't hold stocks. It's
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just that given that stocks might go down, holding stocks in say an environment where you also have leverage
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is is putting yourself under a certain amount of risk. Leverage could include um a mortgage. leverage might include a
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job employ or employment of some kind where your income is very much um subject to the stock market. Those might
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be reasons to limit the stock market part the stock part of your portfolio beyond what say just these wonderful
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expected returns would indicate. That's number one. Number two, these concerns about rare disasters
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have been part of what's been pricing stocks for a long time. And to me, that
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suggests caution on the part of regulators um because I think it's just going to be very hard to eliminate this
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risk. Part of what might be driving events like 2008 are fears about future growth
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prospects and those that those kind of fears are very hard to eliminate. So if you can't eliminate those fears, you can
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make the economy less risky by say um having less leverage on the part of financial
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institutions. People have been researching the stock market for a long time. What sets this
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line of research apart is the focus on these tail events. And um we don't assume for example that risk is normally
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distributed. Now that's a technical term. Um what the normal distribution apply implies is something called the
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bell curve. And the bell curve has thin tails for outcomes. So it basically means that risky things are unlikely to
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happen and it means that risk is very easily measured. So you can if you think that risk follows this bell curve, you
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can almost fool yourself into thinking that you've you understand everything
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about risk when in fact there are these rare events that are out there, not that
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far out there. They're still we see them in the Great Depression. Um but they can have an important part
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effect on stock prices if you introduce them into investors beliefs. I'm looking into links with the
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macroeconomy. Um so employment and unemployment is my um biggest focus right now. So, we're writing down a
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model that can explain why um unemployment and job vacancies are so volatile even though consumption itself
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is very smooth and why these things might track the stock market because recently they
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have tracked the stock market and a big part of it is like investing in the stock market. Investing in hiring is
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something where you need confidence that the economy is going to be stable going
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forward. If you lack that confidence, you don't want to put forth this investment.
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