Detecting prudence and temperance in risk exposure: the hybrid variance framework

Jun Gao; Xiang Gao; Xiaoli Liu

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The authors develop a risk measure to contain the impacts of prudence and temperance on investors’ risk aversion
Empirical results show the negative correlation between returns and HVs in the short term and the positive correlation between returns and HVs in the long term
The paper shows that the HV-based portfolios outperform the market index while providing downside protection during market crashes

Abstract

This paper develops a new risk measure, hybrid variance (HV), to lessen the effects of prudence and temperance on investors’ risk aversion. At the same time, the mean–HV framework gives consistent results with expected utility maximization for all risk-averse investors. Further, this paper shows a negative correlation between returns and HV in the short term and a positive correlation between returns and HV in the long term. Therefore, long–short portfolio strategies are formed based on ranking individual stocks by their average returns and HV. The HV-based portfolios outperform the S&P 500 index over the whole sample period and provide downside protection during market crashes.

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