# On the Determinants of Risk Aversion

A few years ago, The Economist published a particularly interesting article about the determinants of risk aversion, entitled “Risk off: Why some people are more cautious with their finances than others”. Here are some key takeaways from this article:

1. Economists have long known that people are risk-averse, yet the willingness to run risks varies enormously among individuals and over time.
2. Genetics explains a third of the difference in risk-taking; e.g., a Swedish study of twins finds that identical twins had “… a closer propensity to invest in shares” than fraternal ones.
3. Upbringing, environment, and experience also matter; e.g., “…the educated and the rich are more daring financially. So are men, but apparently not for genetic reasons”.
4. People’s financial history has a strong impact on their taste for risk; e.g., “… people who experienced high (low) returns on the stock market earlier in life were, years later, likelier to report a higher (lower) tolerance for risk, to own (not own) shares and to invest a bigger (smaller) slice of their assets in shares.”
5. “Exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses.” Furthermore, a low tolerance for risk is linked to past emotional trauma.

# VXX, the exchange-traded version of the CBOE Volatility Index (AKA “VIX”)

The first exchange-traded product that allowed investors to bet directly on future stock swings will expire this month. Here is a look at how the transition will work and how the end for VXX came to be.

# Things That Make You Go Hmmm…

Financial historian John Stuart Gordon’s Wall Street Journal essay provides some particularly fascinating examples of rare events from the 19th, 20th, and 21st centuries!

Odds are these historical coincidences will strike you as unlikely.

# What Drove Jack Bogle to Upend Investing

This week’s Intelligent Investor column in the Wall Street Journal presents an homage to the memory of Jack Bogle, the founder of Vanguard Group. Mr. Bogle passed away this past Wednesday at the age of 89, and as the inventor of index investing, he is arguably one of the most important public figures in the practice of finance of the past 50 years. Burton Malkiel’s WSJ op-ed in today’s paper entitled “The Secrets of Jack Bogle’s Investment Success” is also a must read!

# The Index Fund featured as one of “50 Things That Made the Modern Economy”

Tim Harford also features the index fund in his “Fifty Things That Made the Modern Economy” radio and podcast series. This 9 minute long podcast lays out the history of the development of the index fund in particular and the evolution of so-called of passive portfolio strategies in general. Much of the content of this podcast is sourced from Vanguard founder Jack Bogle’s September 2011 WSJ article entitled “How the Index Fund Was Born” (available at https://www.wsj.com/articles/SB10001424053111904583204576544681577401622). Here’s the description of this podcast:

“Warren Buffett is the world’s most successful investor. In a letter he wrote to his wife, advising her how to invest after he dies, he offers some clear advice: put almost everything into “a very low-cost S&P 500 index fund”. Index funds passively track the market as a whole by buying a little of everything, rather than trying to beat the market with clever stock picks – the kind of clever stock picks that Warren Buffett himself has been making for more than half a century. Index funds now seem completely natural. But as recently as 1976 they didn’t exist. And, as Tim Harford explains, they have become very important indeed – and not only to Mrs Buffett.”

Warren Buffett is one of the world’s great investors. His advice? Invest in an index fund

# Insurance featured as one of “50 Things That Made the Modern Economy”

From November 2016 through October 2017, Financial Times writer Tim Harford presented an economic history documentary radio and podcast series called 50 Things That Made the Modern Economy. This same information is available in book under the title “Fifty Inventions That Shaped the Modern Economy“. While I recommend listening to the entire series of podcasts (as well as reading the book), I would like to call your attention to Mr. Harford’s episode on the topic of insurance, which I link below. This 9-minute long podcast lays out the history of the development of the various institutions which exist today for the sharing and trading of risk, including markets for financial derivatives as well as for insurance.

“Legally and culturally, there’s a clear distinction between gambling and insurance. Economically, the difference is not so easy to see. Both the gambler and the insurer agree that money will change hands depending on what transpires in some unknowable future. Today the biggest insurance market of all – financial derivatives – blurs the line between insuring and gambling more than ever. Tim Harford tells the story of insurance; an idea as old as gambling but one which is fundamental to the way the modern economy works.”

# On the relationship between the S&P 500 and the CBOE Volatility Index (VIX)

Besides going over the course syllabus during the first day of class on Tuesday, January 15, we will also discuss a particularly important “real world” example of financial risk. Specifically, we will look at the relationship between stock market returns (as indicated by daily percentage changes in the SP500 stock market index) and stock market volatility (as indicated by daily percentage changes in the CBOE Volatility Index (VIX)):

As indicated by this graph from page 21 of the lecture note for the first day of class, daily percentage changes on closing prices for VIX and the SP500 are strongly negatively correlated. In the graph above, the y-axis variable is the daily return on the SP500, whereas the x-axis variable is the daily return on the VIX. The blue points represent 7,311 daily observations on these two variables, spanning the time period from January 2, 1990 through January 7, 2019. When we fit a regression line through this scatter diagram, we obtain the following equation:

${R_{SP500}} = 0.0588 - 0.1139{R_{VIX}}$,

where ${R_{SP500}}$ corresponds to the daily return on the SP500 index and ${R_{VIX}}$ corresponds to the daily return on the VIX index. The slope of this line (-0.1139) indicates that on average, daily VIX returns during this time period were inversely related to the daily return on the SP500; i.e., when volatility as measured by VIX went down (up), then the stock market return as indicated by SP500 typically went up (down). Nearly half of the variation in the stock market return during this time period (specifically, 48.73%) can be statistically “explained” by changes in volatility, and the correlation between ${R_{SP500}}$ and ${R_{VIX}}$ comes out to -0.696. While a correlation of -0.698 does not imply that ${R_{SP500}}$ and ${R_{VIX}}$ will always move in opposite directions, it does indicate that this will be the case more often than not. Indeed, closing daily returns on ${R_{SP500}}$ and ${R_{VIX}}$ during this period moved inversely 78.4% of the time.