Want better returns? Forget risk. Focus on fear

Introduction

Traditionally, financial theory teaches investors that returns are compensation for risk. Higher risk → higher expected return (if taken properly, over time). But recent work, particularly the paper “Fear, Not Risk, Explains Asset Pricing” by Robert D. Arnott and Edward F. McQuarrie (2025), argues for a paradigm shift. Instead of focusing on volatility-based risk (standard deviation etc.), one should pay more attention to fear—both fear of loss and fear of missing out—as driving returns.

This essay examines that thesis: what “focusing on fear” means, how it differs from the conventional risk-framework, what evidence supports it (or opposes it), and what practical implications it has for investors. I conclude with reflections and a balanced view.

What is “fear” in this context, versus “risk”

• Risk (traditional finance view): Usually quantified as volatility (variance, standard deviation), or via beta (how an asset moves relative to the market). In the CAPM (Capital Asset Pricing Model), expected return is an increasing function of risk. Modern Portfolio Theory (MPT) builds on this. Risk is probabilistic uncertainty: things you can model, estimate, even if imperfectly.
• Fear (as per Arnott & McQuarrie): More about subjective perception, behavioral biases, emotions, and “radical uncertainty.” Fear is not symmetric: fear of downside (loss) and fear of missing upside (FOMO). It reflects how real investors respond under uncertainty—not just measurable volatility but what makes them uneasy. Fear may manifest in crowd behavior, in exaggeration of downside, in rapid swings away from fundamentals when panic or euphoria hits. The authors suggest that fear is more volatile and more useful than volatility metrics in explaining asset pricing.
• Why “forget risk”?: Because, according to Arnott & McQuarrie, risk-as-volatility fails to reliably predict returns. The standard deviation measure often fails empirical tests: high volatility doesn’t always produce higher returns, especially over longer horizons. Fear, in contrast, better aligns with when investors demand premiums, when they sell, when they buy, etc.

Evidence and arguments for focusing on fear

1. Empirical failings of risk-based models
   Arnott & McQuarrie point out that CAPM, MPT etc. cannot consistently explain asset pricing over different markets and periods. The reward-for-volatility assumption often breaks down. Highly volatile assets do not always yield higher excess returns.
2. Behavioral economics / psychology
   Humans are not fully rational. Emotions matter. Loss aversion, prospect theory, overreaction, herding, fear of missing out (FOMO), fear of loss—all influence decisions. These biases produce market behavior not predicted by purely risk-adjusted expected return models.
3. Market cycle evidence
   Periods of extreme fear (crashes, crises) tend to provide higher long-run returns for those who hold or buy in, because fear pushes prices below fundamental value. Conversely, when fear is low (or absent) and greed or complacency dominate, asset valuations stretch, reducing future expected returns. This pattern suggests fear (or its absence) is more predictive of overpriced/underpriced conditions than raw volatility.
4. The role of radical vs probabilistic uncertainty
   Traditional risk models assume probabilistic uncertainty—that one can assign probabilities to outcomes. But many of the things impacting markets (politics, innovation, regulatory shifts, crises) are radically uncertain. Fear arises from that kind of uncertainty, not from measurable volatility. Because fear responds more to uncertainty that cannot be quantified, measuring fear can capture what risk measures miss.

Arguments / challenges against the “fear over risk” paradigm

• Measurement of fear is difficult: While volatility is quantifiable, fear is subjective. How do you reliably measure fear—survey indicators, sentiment metrics, options markets, volatility over expectation (VIX), etc.? These tools are less precise and often lag or misread true investor emotion.
• Risk still matters: Even if fear is a powerful driver, risk (especially downside risks) remains real. Volatility is one component of risk; other risks (liquidity risk, business risk, financial leverage, tail risk) need to be managed. Ignoring “risk” entirely is dangerous.
• Practical implementation challenges: It’s easier in theory to say “buy when fear is high, sell when fear is low,” but in practice, timing fear is hard. Fear can endure for long periods; valuations can get stretched slowly. Behavioral biases can misinterpret fear signals (e.g. is fear justified?).
• Possibility of overreaction: Markets can overshoot on fear—sometimes fears are irrational, sometimes fears are delayed. Betting purely on fear could lead to catching falling knives, or investing too early during fear, or being shaken out prematurely.
• Risk-return trade-off still useful: Some investors still need to quantify downside exposure, especially if they have constraints (capital they cannot afford to lose, obligations, etc.). For them, risk in the traditional sense remains relevant.

Implications for investors if fear is the focus

If one accepts that focusing on fear yields better returns or better decision-making than focusing mainly on risk (volatility), what should an investor change?

1. Sentiment tracking and awareness
   • Monitor fear/greed indices, investor sentiment surveys.
   • Use indicators like option-market implied volatilities, put/call ratios.
   • Pay attention to macro uncertain events, geopolitical risk, news flow.
2. Buy when others are fearful, sell (or be cautious) when others are greedy or complacent
   This is essentially contrarian investing. When fear is high, assets may be undervalued; when markets are euphoric, risk of a pullback is higher.
3. Margin of safety / quality investing
   Fear signals can help identify cheaper valuations or higher uncertainty that justifies a margin of safety. Choosing companies/businesses with strong fundamentals helps survive fearful periods.
4. Diversification and position sizing
   Even if fear is driving returns, exposure needs to be managed so that fear doesn’t lead to ruin. Don’t put too much weight where fear could cause severe losses.
5. Behavioral discipline, emotional control
   Recognize when fear is influencing decisions, especially in negative ways. Have pre-defined rules, or plans that force discipline (e.g. rebalancing thresholds).
6. Long-term orientation
   Because fear often drives great buying opportunities, but those may take long time horizons to play out. Being patient helps.

Case Examples / Supporting Illustrations

• Warren Buffett’s famous aphorism: “Be fearful when others are greedy and greedy only when others are fearful.” That captures the idea.
• During market crashes (e.g. 2008, COVID-19 panic in early 2020), fear peaked → after markets bottomed → long-term returns for those who held or invested new capital were very high.
• Research shows that investors who panic and sell in fear often lock in losses, whereas those who withstand fear and wait for recovery tend to outperform.

Balanced view & practical advice

While focusing on fear has merit, a balanced approach is probably best. Here are some advices:

• Don’t abandon risk entirely: Keep track of risk exposure (volatility, business risk, financial risk). Use risk frameworks to ensure you aren’t exposed to catastrophic events.
• Use fear as a complementary signal: Fear should be one input among many—valuation, fundamentals, macro outlook, risk metrics.
• Have a plan for different scenarios: Bear markets, corrections, bubbles—they come with fears. Having scenario plans helps avoid knee-jerk reactions.
• Avoid acting purely on emotion: Just because fear is high doesn’t mean you should rush in; sometimes it’s justified. Similarly when fear is low, complacency might be dangerous.
• Know your own psychology and constraints: What levels of loss can you tolerate? What time horizon do you have? What kind of pain can you endure without abandoning your strategy? Personal risk tolerance remains real even if your analytic framework shifts.

Conclusion

The idea “Want better returns? Forget risk. Focus on fear” is provocative but increasingly compelling. While risk (in the classical sense) has been the cornerstone of financial theory, empirical evidence suggests that it often fails to fully explain real investor behavior and market pricing. Fear—both fear of loss and fear of missing out—along with emotional, subjective responses to uncertainty, may be more powerful in explaining market cycles, returns, and mispricings.

However, fear is harder to measure, and acting on fear is psychologically difficult. For most investors, the optimal strategy is not to abandon risk frameworks altogether but to integrate fear as a signal—using it to recognize opportunities, avoid overpaying, and maintain discipline. Those who can master the emotional dimension of investing—who can resist panic when others are panicking, and act when others are fearful—are more likely to achieve superior returns over the long run.