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In finance, it's generally believed that taking on more risk should lead to higher returns. It doesn't. It's a puzzle that has long confused financial experts.

Research conducted by University of Alabama Assistant Professor of Economics Soroush Ghazi and UA Associate Professor of Economics Mark Schneider suggests the answer lies in how investors feel about uncertainty. When it comes to the stock market, it's not just about how much risk there is, but also how people feel about that risk.

The research, in Management Science titled "Market Ambiguity Attitude Restores the Risk-Return Tradeoff," also includes Jack Strauss as an author. It looks at how investors' attitudes toward market ambiguity—or uncertainty—can affect the link between risk and return.

The dark side of looking on the bright side

"Our solution is to propose that there's a missing variable that moderates this risk-return relationship," Schneider said. "A measure of market optimism that we derive from a model in behavioral economic theory should basically weaken this relationship… it should be eroded by higher market optimism."

When investors are more pessimistic (ambiguity-averse), the traditional risk-return relationship holds; higher risk leads to higher expected returns. When investors are more optimistic (ambiguity-seeking), this relationship weakens or disappears.

"If the volatility is being caused by optimism, our finding is basically that you do not see a strong relationship between risk and return at that time," Ghazi said.

"Including market ambiguity attitude in models helps explain why the risk-return tradeoff is inconsistent in empirical data. Understanding and measuring market ambiguity attitude can improve predictions of stock returns and provide insights into market behaviors during different economic conditions.

"The Sharpe ratio indicates how much return you earn for a given level of risk. Ideally, you want high returns with low risk. Our theory can help construct portfolios with substantially higher Sharpe ratios," Ghazi said.

In essence, investors' collective feelings about uncertainty significantly influence the risk-return dynamics in the stock market. By accounting for these attitudes, we can better understand and predict market behavior.

Their optimism measure showed impressive predictive power beyond returns.

"We show that basically all of the 10% crashes that occurred between 1990 and 2022 were preceded by high levels of optimism," Schneider said. "Similarly, about 70% of the NBER recession periods over that 30-year period were preceded by periods of high market optimism."