For decades, financial experts have been puzzled by a strange inconsistency in the stock market: risk doesn’t always lead to higher returns.
The basic idea in finance is simple—if you take on more risk, you should expect to earn more. But in real life, this pattern often doesn’t hold up.
Now, a new study suggests that the missing piece of the puzzle might be how investors feel about uncertainty.
Researchers from the University of Alabama—Assistant Professor Soroush Ghazi and Associate Professor Mark Schneider—along with Jack Strauss, explored the role of investor attitudes in shaping stock market behavior.
Their research, published in Management Science, shows that it’s not just how risky the market is that matters—it’s also how investors emotionally respond to that risk, especially when things are uncertain or ambiguous.
They focused on something called “market ambiguity attitude,” which refers to how much people like or dislike dealing with uncertain situations.
Some investors feel anxious and cautious when they face uncertainty, while others are more optimistic and willing to take risks. The researchers found that this emotional response to uncertainty plays a key role in whether or not the usual link between risk and return holds true.
When investors are feeling pessimistic—what the researchers call “ambiguity-averse”—the traditional pattern shows up: more risk usually means more return. But when investors are feeling overly optimistic and don’t mind uncertainty—when they’re “ambiguity-seeking”—the risk-return connection breaks down.
This might explain why risky investments don’t always lead to bigger rewards.
Ghazi explains that including this attitude toward ambiguity in stock market models helps make better sense of why the risk-return rule sometimes falls apart. It also helps predict stock market movements more accurately.
In practical terms, this understanding could lead to building smarter investment strategies, including portfolios with better performance, as measured by the Sharpe ratio—a tool that compares return with risk.
One of the most striking findings in the study is how well investor optimism predicted major market events. The researchers discovered that every single 10% market drop (also called a correction) between 1990 and 2022 was preceded by a surge in investor optimism. Similarly, around 70% of U.S. recession periods during that time also followed high levels of market optimism.
In short, when it comes to investing, it’s not just about crunching numbers. How people feel about risk and uncertainty—especially when they’re too hopeful—can have a huge impact on market outcomes. By paying attention to these emotions, we may finally be able to solve one of finance’s most frustrating mysteries.
