Field of play
If you can look into the seeds of time
The topic in this post is risk. In my last post, I wrote there are four words that cause investors much grief. They are random, unpredictable, risk and uncertainty. That post dealt with the word random. Today I look at the word ‘risk’ with a look-in about uncertainty.
One would have thought that everything that could be said about risk would already be written. But low and behold, I read in the Buttonwood column of the most recent Economist magazine of August 9, 2025 that a new paradigm has been proposed that would replace risk in explaining asset pricing. It is fear.
Fear paradigm for asset pricing
The proposed new paradigm comes from Robert D. Arnott of Research Affiliates, LLC and Edward F. McQuarrie of Santa Clara University – Leavey School of Business.
Research Affiliates tells us that “partnering with some of the world’s largest investment managers, we deliver mutual funds, ETFs, commingled funds, and separately managed account solutions. As of June 30, 2025, the firm has over $159 billion in assets using strategies developed by Research Affiliates.”
Edward F. McQuarrie received his Ph.D. in social psychology from the University of Cincinnati in 1985. He has published in three broad areas: 1) consumer response to advertising, with a focus on rhetoric and narrative; (2) qualitative research techniques and market research appropriate to technology products; and 3) emergent online consumer behaviors.
The title of their paper is Fear, Not Risk, Explains Asset Pricing and was published May 8, 2025.
The paper is written from the point of view of quants who have grown up with the Capital Asset Pricing Model (CAPM), Modern Portfolio Theory (MPT), the Efficient Market Hypothesis (EMH) and Risk Theory.
In the paper the authors make what is probably a traumatic admission. The idea that volatility is a measure of, or proxy, for risk is acknowledged to be wrong. They propose a new ‘explanation for asset pricing’ and suggest that fear can be used as the replacement ‘measure’ in Risk Theory. The authors write of a paradigm shift.
In effect they acknowledge that going down the Capital Asset Pricing Model rabbit hole with Alice did not get them to Wonderland. Their solution is to go further down the same rabbit hole.
Authors’ hypothesis
The authors explain that over the last 60 years quants have said that asset pricing is explained by risk. The whole edifice was called Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM). In that telling, risk refers to variance. Variance is volatility. In the parlance of quants, this was called Risk Theory (sometimes Risk Hypothesis or Risk Paradigm). The problem is that this model has essentially failed, as the authors admit.
As described by Professor Cunningham, the Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, MPT and Risk Theory can be described as follows: “It says that you can eliminate the peculiar risk of any security by holding a diversified portfolio – that is, it formalizes the folk slogan ‘don’t put all your eggs in one basket.’ The risk that is left over is the only risk for which investors will be compensated, the story goes. This leftover risk can be measured by a simple mathematical term – called beta – that shows how volatile the security is compared to the market. Beta measures this volatility risk well for securities that trade on efficient markets, where information about publicly traded securities is swiftly and accurately incorporated into prices. In the modern finance story, efficient markets rule.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. New York: Lawrence A. Cunningham. 1998) p12 (Emphasis Added)
Messrs. Arnott and McQuarrie point out: “CAPM posits a mathematical relationship between return and risk, describing the way homo economicus would behave in a perfectly rational world.” (Emphasis Added)
The problem is that, per Richard Thaler and Daniel Kahneman and behavioral psychology, a Human is simply a normal human being who is neither fully rational nor completely selfish. There is a world of difference between a Human and an Econ, also known as Homo Economicus.
From Risk Theory to Fear Theory
So, they propose replacing Risk Theory with Fear Theory.
The authors write: “Key to the risk paradigm [risk theory, risk hypothesis] is the idea that risk is rewarded in proportion to the risk assumed. As the equity risk premium literature has it, no rational investor would assume the expected risk of owning stocks without some reasonable expectation of a commensurate reward.” (Emphasis Added)
They go on to look at years of data and conclude: “These results are not compatible with the hypothesis that risk, as measured by standard deviation [risk theory], provides an index of the rewards that investors demand to receive (i.e., that riskier assets are priced to deliver higher returns when held for a long period). The precision with which risk can be estimated proves to be a distraction, with its precise measurement not helping as far as prediction is concerned.” (Emphasis Added)
The humble confession for quants is as follows: “Even as the anomalies have piled up and factors multiply like bacteria, risk theory has remained dominant. How could a theory that has been so repeatedly and uniformly contradicted by empirical data continue to be held out to students and practitioners as the best scientific representation of investor behavior?” (Emphasis Added)
They suggest that “…the persistence of the CAPM, despite overwhelming evidence of its empirical failure, poses a conundrum.” I think it poses more than a conundrum.
The final admission by the authors: “Either CAPM represents faith, not science, or falsification is not actually a useful account of how the social sciences proceed.”
Through his 1958 book The Affluent Society, John Kenneth Galbraith popularized the expression Conventional Wisdom. Galbraith writes: “It is why men react, not infrequently with something akin to religious passion, to the defense of what they have so laboriously learned.” (Galbraith, 1958) p7
New paradigm
The paper explains the new thinking: “Observed fluctuations in the realized equity premium or deficit require an explanation in terms of something much more volatile than objective measures of the risk present in stock and bond assets. Fear is an appropriate response when investors face radical uncertainty rather than probabilistic uncertainty, which can be readily quantified using a metric such as standard deviation.”
An aside, a distinction between radical uncertainty and probabilistic uncertainty is fanciful. I think they intend to represent beta as probabilistic uncertainty, a false notion anyway. As far as I am concerned uncertainty is uncertainty. You don’t need to added a fancy word like ‘radical’.
They propose “that an aversion to both upside and downside variance should be replaced with a preference for upside risk [fear of missing out FOMO] and an aversion to downside risk [fear of loss FOL].” In their telling they equate fear and aversion.
There is no mathematics companion offered for the new paradigm. They invite other quants to contribute to the new approach. They suggest: “The mathematics of FOMO and FOL will be far more daunting than the mathematics of CAPM and the standard utility framework.” This is more than a tough challenge, it can’t be done. They thought risk could be measured by measuring beta. It couldn’t. Now they suggest measuring fear or aversion. It also can’t be done. Sentiment indicators will not get them there. Nor will AI.
Where it all breaks down
Here is how the authors make the pivot to human behavior. They write: “A fear-based theory of asset pricing does not dismiss the homo economicus assumption that investors can behave rationally. Recall that in the context of portfolio choice, it is rational for the risk-averse investor to allocate less to the risk portfolio. But the aversion that drives that rational choice is not itself rational. It is fear.” (Emphasis Added)
Four years ago, I wrote a post Fear and investing . The post begins: “The house of fear has many windows. In this post I will take a look into some of those windows. Like many English words ‘fear’ has many meanings and nuances. There are fear of financial loss, fear of failure, fear of being seen as foolish, fear of losing a gain, fear of getting whipsawed, fear based on vivid memories of recent events, fear of missing out, and so on.”
Here’s where I’m going with this. Warren Buffett famously relates in his advice to savvy investors: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
Further, the authors cling to the rational homo economicus. They write about the risk averse investor as being rational. They would be on firmer ground to describe the rational investor as risk savvy. In behavioral psychology the terms risk averse and risk seeking have very special meanings.
Kahneman defines risk aversion and risk seeking behavior in a special way. Risk aversion is an unwillingness to take on a risk in spite of the fact that the likely reward amply justifies the risk taken. Similarly, risk seeking has a specific meaning. Risk seeking is taking on a risk in spite of the likely reward not justifying the risk taken. Risk aversion and risk seeking behaviors are pathological, in the sense that they work against what would be in your best interest. A savvy investor is risk savvy.
Slow to wake up
The quant community has been a bit slow waking up to the fact that their Risk Theory neither works nor is necessary.
Warren Buffett is reported to have written in the Outstanding Investor Digest August 8, 1997: “Finance departments teach that volatility equals risk. Now they want to measure risk. And they don’t know any other way, they don’t know how to do it, basically. So they say that volatility measures risk. I’ve often used the example of the Washington Post stock when we first bought it: In1973, it had gone down almost 50%, from a valuation of the whole company of close to say $180 or $175 million, down to maybe $80 million or $90 million. And because it happened very fast, the beta of the stock had actually increased. A professor would have told you that the stock of the company was more risky if you bought it for $80 million than if you bought it for $170 million, which is something that I’ve thought about ever since they told me that 25 years ago. And I still haven’t figured it out.”
More from Warren Buffett. This is from an article in the February 27, 2012 issue of Fortune. The article is titled: Why stocks beat gold and bonds. Buffett says:
“Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire Hathaway (BRKA) we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power — after taxes have been paid on nominal gains — in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.
From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a nonfluctuating asset can be laden with risk.” (Emphasis Added)
So, Warren Buffett got there decades ago and quants are only now fessing up to the fact that volatility is not risk nor is it a proxy for risk.
What risks are there for investors?
Warren Buffett wrote in his 1993 Chairman’s letter: “In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing or how much borrowed money the business employs. He may even prefer not to know the company’s name. What he treasures is he price history of its stock. In contrast, we’ll happily forego knowing the price history and instead will seek whatever information will further our understanding of the company’s business.” (Buffett, 1998) p76
These last two quotes from Buffett highlight what risk really is. It is business risk, currency risks, interest rate risks, inflation risk, liquidity risk, idiosyncratic risk, catastrophic risk, fat tail risk, black swan risk, systemic risk, political risk and plain old uncertainty, as in the following from William Shakespeare:
“If you can look into the seeds of time,
And say which grain will grow and which will not,
Speak then to me.”
– Macbeth, Act 1, Scene 3
Onward to value investing
For the individual investor, Buffett’s advice is straightforward. This from the 1996 Chairman’s letter: “Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital. To invest successfully, you do not need to understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets. You may, in fact, be better off knowing nothing of these.” (Buffett, 1998) p93 (Emphasis Added)
Conclusion
There is a simpler explanation for asset pricing. The whole edifice called Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model was never necessary in the first place.
Prices are simply what’s offered in the stock market. When fear of loss (FOL) abounds, prices can fall below fair value. When fear of missing out abounds (FOMO), prices can exceed fair value. A savvy investor will try to buy superb companies at knock down prices and sell at extreme overpricing. Of course, the devil is in assessing fair value.
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Readers wishing to dig deeper into the topic of risk and investing might take a look at the following posts:
The joy of higher return with no more risk
Buying stocks in your happy zone
Many investors just don’t understand the risk/reward trade-off
The price of risk in equity markets
On the subject of risk and behavioral psychology, check out these posts:
Sentiment and the four faces of risk
A Daniel Kahneman core achievement applied to investing
Beat the behavioral gap and take advantage of Mr. Market’s foibles
Some other posts that touch on the area of volatility, risk and uncertainty
Let’s cut to the heart of how risk and uncertainty impact diversification
A coward’s primer for investors per Paul Samuelson
How much riskier are stocks than bonds?
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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