As we’ve previously seen many of the strange anomalies that affect investors have a nasty habit of disappearing, just as soon as people recognise that they exist. This wantonly random behaviour gives fuel to the last remaining adherents of the efficient markets hypothesis who can point out that despite the best attempts of behavioural financiers the evidence keeps on vanishing. Despite the mysterious case of the missing anomalies there’s one that resolutely refuses to go away, squatting in the middle of the markets like a recalcitrant and extremely ugly toad. Rather ungraciously stocks continue to bounce around like a jitterbugger on speed. Regardless of everything else it’s volatility, the last anomaly, that keeps on giving. And then taking away. And then giving back again.
Stuff Happens
High volatility – the nasty habit of share prices to veer about in a sickening rollercoaster fashion rather than trending along near some fundamental value – is a worryingly unpredicted emergent property of markets. Observing the apparently irrational bouncing about of stock valuations one might be tempted to wonder if this is happening less because of the markets adjusting prices due to changes in fundamentals and more, well, because sometimes stuff just happens. The possibility that prices wander around in a random fashion for no particular reason – rather like the plot of a struggling sci-fi series trying to find a decent dénouement – is enough to give several generations of economists palpitations, not to mention unnerving the serried ranks of financial analysts who could find themselves put out of business by a decent Brownian motion generator such as a nice cup of tea. Under such circumstances they might actually feel better if it turned out that prices move about because people are irrational.
Volatility Rules
As far back as 1981 Robert Shiller pointed out that the fundamental valuation of the S&P500 computed historically – which roughly equates to the value of the index as a discounted stream of future dividends – followed an extremely stable trend. Basically, if you think of markets as efficient their fundamental value looks pretty constant over time. Yet, at one and the same time, the S&P itself wobbled around this stable valuation like a politician trying to avoid a paternity suit. Not unreasonably Shiller pointed out that it rather looked like there was unexplained volatility in the…
