FRBSF Economic Letter
2002-32; October 25, 2002
Stock Market Volatility
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In recent months, it has not been unusual to see the value of major
stock indexes, such as the S&P 500, change by as much as 3% in a single
day. Unfortunately for many investors, the general direction of those
changes has been downward. For some researchers in financial economics,
the interesting question is: what drives the volatility itself? The evidence
they have uncovered over the last few decades sheds light on the efficiency
of the stock market and points to some important implications for economic
forecasters and investors. In particular, it suggests that the degree
of stock market volatility can help forecasters predict the path of the
economy's growth; furthermore, changes in the structure of volatility
imply that investors now need to hold more stocks in their portfolios
to achieve diversification. In this Economic Letter I survey the
academic literature on the properties and causes of stock market volatility,
focusing on the debate on whether the stock market varies excessively,
how volatility changes over time, and some of the underlying components
Excess stock market volatility and dividends
Stock market performance is usually measured by the percentage change
in the stock price or index value, that is, the returns, over a set period
of time. One commonly used measure of volatility is the standard deviation
of returns, which measures the dispersion of returns from an average.
Since the beginning of 1997, the standard deviation of daily returns is
1.3% for the S&P 500 Index, 2.2% for the NASDAQ, and 1.3% for the
Dow Jones Industrial Average (see Figure 1).
If the stock market is efficient, then the volatility of stock returns
should be related to the volatility of the variables that affect asset
prices. One candidate variable is dividends. But research conducted in
the early 1980s suggests that variation in dividends alone cannot fully
account for the variation in prices (see LeRoy and Porter 1981 and Shiller
1981). Prices are much more variable than are the changes in future dividends
that should be capitalized into prices. Asset prices apparently tend to
make long-lived swings away from their fundamental values. This fact turned
out to be equivalent to the finding that, at long horizons, stock returns
displayed predictability. Thus, the literature on excess volatility broached
the possibility that the stock market may not be efficient.
In the excess volatility literature, the researchers understood that
the dividends that are capitalized in the stock price arrive in the future
and need to be "discounted" back to the present using a discount
rate. In the early research it was assumed that this discount rate was
constant. However, discount rates depend on investors' preferences for
risk, which could very well change over time. Therefore, stock market
volatility may not be excessive if discount rates are variable enough.
Thus, the real contribution of the excess volatility literature was to
call attention to the fact that corporate dividends are simply too smooth
a series to account for the high volatility in prices. Subsequent research
necessarily focused away from the payout policy of firms and toward the
characteristics of investors and of actual stock market trading.
Persistence of stock market volatility
Stock market volatility tends to be persistent; that is, periods of high
volatility as well as low volatility tend to last for months. In particular,
periods of high volatility tend to occur when stock prices are falling
and during recessions. Stock market volatility also is positively related
to volatility in economic variables, such as inflation, industrial production,
and debt levels in the corporate sector (see Schwert 1989).
The persistence in volatility is not surprising: stock market volatility
should depend on the overall health of the economy, and real economic
variables themselves tend to display persistence. The persistence of stock
market return volatility has two interesting implications. First, volatility
is a proxy for investment risk. Persistence in volatility implies that
the risk and return tradeoff changes in a predictable way over the business
cycle. Second, the persistence in volatility can be used to predict future
economic variables. For example, Campbell, et al. (2001) show that stock
market volatility helps to predict GDP growth.
Components of stock market volatility
Researchers have sought to analyze the relative importance of economy-wide
factors, industry-specific factors, and firm-specific factors on a stock's
volatility. This approach borrows from modern asset pricing theory and
its emphasis on so-called factor models, or models that assume a firm's
stock return is governed by factors such as the overall market return,
the return on a portfolio of firms sampled from the same industry, or
even changes in economic factors such as inflation, changes in oil prices,
or growth in industrial production. If returns have a factor structure,
then the return volatility will depend on the volatilities of those factors.
Campbell, et al. (2001) assume the factors are the overall market return,
an industry return (e.g., financial, industrial, etc.), and an idiosyncratic
noise term that captures firm-specific information. They document the
important empirical fact that while volatility moves considerably over
time, there is not a distinct trend upwards or downwards. More interestingly,
however, since 1962, there has been a steady decline in stock market volatility
attributed to the overall market factor; that is, the common volatility
shared across returns on different stocks has diminished over that period.
The variation ascribed to firm-specific sources, by contrast, has risen.
The implication for investors, then, is that they need to hold more stocks
in their portfolios in order to achieve diversification.
Economists have long been interested in the patterns of stock market
volatility. Their research on excess volatility relative to dividends
found that volatility tends to ebb and flow; subsequent research found
that periods of high volatility are persistent and occur during periods
of stock market declines, and that the stock market volatility associated
with systematic factors has been declining over time. These academic findings
may offer little consolation to today's investor for whom volatility means
portfolio losses, but the research has yielded important insights into
how stock market information can help forecast economic variables, and
how investors can construct portfolios that can minimize volatility.
Campbell, J., M. Lettau, B. Malkiel, and Y. Xu. 2001. "Have Individual
Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic
Risk." Journal of Finance 56, pp. 1-43.
LeRoy, S., and R. Porter. 1981. "The Present Value Relation: Tests
Based on Variance Bounds." Econometrica 49, pp. 555-574.
Schwert, W. 1989. "Why Does Stock Market Volatility Change Over Time?"
Journal of Finance 44, pp. 1,115-1,153.
Shiller, R. 1981. "Do Stock Prices Move Too Much to Be Justified
by Subsequent Changes in Dividends?" American Economic Review
71, pp. 421-436.