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Risk premiums are often cited as ideal tools for constructing asset allocations, but they suffer from two drawbacks. First, they are non-observable, nor can they be reliably estimated. Second, they are not constant. Volatility can be taken as a more suitable measure. Though inconstant and hard to predict as well, volatility falls into three distinct modes. Crucially, it is an observable phenomenon through implied volatilities. Like risk premiums, it offers a reliable barometer enabling investors to assess economic and systemic risks.

Unlike the subject matters usually covered in our Topic of the Month articles, this month’s is more technical, but significant because of its crucial influence on portfolio construction. We have focused on calculating expected returns from asset classes over the short term (around three months). This article dovetails neatly with our analysis of how to calculate expected long-term returns from asset classes presented in this year’s inaugural issue of our new annual publication, Perspectives – Special Edition (page 9). 

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