Question

Hello my dear students in less than one paragraph discuss if the stock market and individual stocks are more volatile today than in the past. Further discuss using the information from a study by campbell, lettau,malkiel and xu,2001. this study looked at 9000 firms from 1962-97.they decomposed the stock into market wide, industry-wide and firm specific volatility. they found that while there were periods of increase volatility, for exampleduring the oil crisis in the 1970s, average market volatility as mearsured by standard deviation has remained relatively stable over time-14% in the 1970s 16% in the 1980s and 11% in the 1990s. industry volatility has also remaind stable over time. Firm specific volatility, on the other hand , more doubled from 1962 to 1997 the period of the study. The most volatile stocks moved 25% in a single day. Firm specific volatility was 65% of total volatility in 1962 and 76% in 1997. Honorable students why is it that individual stocks can be more volatile , yet not the market as a whole.A university of Nevada study at the sam time found that 100 stocks were needed to achieve complete diversification. The university of Nevada study found that the mean culprits advocating too few stocks for diversification were textbooks,professional journals and the wall street journal(which has since printed a story about this study). some individuals choose to hold portfolios with a smaller number of stocks because it is difficult to research a large number of stocks. Why are individual stocks more volatile? Why do investors think the market as a whole is more volatile?

Answer 1

Diversification

It is well known that increasing the number of stocks in the portfolio increases the diversification, which effectively reduces the risk in the portfolio. Diversification means that different stocks of the portfolio respond to different factors and all of the stocks do not go down in value at the same time; thereby reducing the probability of severe losses during bear phases.

Ideally there should be only 20-30 stocks in an investors portfolio because it has been observed by many researchers that diversification benefits gets reduce beyond 30 stocks.

Every stock in the portfolio requires regular monitoring by the investor. It is a mix of continuous monitoring, quarterly monitoring and annual monitoring.

The investor should have only as many stocks that she can monitor effectively given the time & effort, which she can spare for her portfolio. Inability to monitor and staying updated about her stocks regularly might present her with surprise developments related to her portfolio stocks and increase the risk.

Why are individual stocks more volatile?

The relationship between risk and returns plays an important role in the asset pricing literature. It has long been recognized that both expected return and volatility change over time.

Stock prices equal the sum of all the discounted future dividends. Strong cross-sectional relationship has been found between return volatility and dividend yield. But since dividends are under the discretion of corporate managers who normally set dividend pay-out ratios to meet their companies’ long term growth needs and often iron out the wrinkles in corporate earnings to provide smooth dividend payments, the time-series relationship between the return volatility and the dividend volatility may often be distorted. We, therefore, focus on earnings rather than on dividends. Although earnings can be manipulated by managers too to some extent, excessive manipulation is not without the risk of criminal investigation as recent events indicate. Earnings, therefore, reflect more information about future profitability of the firm than do dividends which are under complete legitimate discretion of the managers.

The prices of some stocks are highly volatile. That unpredictability makes the stock a more risky investment. As a result, investors want a higher return for the increased uncertainty. Companies with highly volatile stocks need to grow profitably. They must show a dramatic increase in earnings and stock prices over time or pay very high dividends.

Investors have developed a measurement of stock volatility called beta. It tells you how well the stock price is correlated with the Index. If it moves perfectly along with the index, the beta will be 1.0. Stocks with betas that are higher than 1.0 are more volatile than the index. Stocks with a beta less than 1.0 are not as volatile.

Why do investors think the market as a whole is more volatile?

Perceptions and emotions move individual stock prices and the overall market in the near term. If investors feel that good times are ahead for the economy and/or an individual company, the prices of those securities will probably go up until that perception changes. Investors’ perceptions and emotions are heavily influenced by news events. So when the government reports one day that unemployment is dropping, the market could do quite well that day.

Nobody knows exactly which news item moves the market in any particular day but investors definitely fall victim to the herd mentality. Once a few big players react strongly to a story, everyone piles on. So if something happens that makes people think or feel differently about the market as a whole or an individual company, the prices in question can really move over the short run.