ANZ Finance blog | Are Share Prices Too Volatile? | McGraw Hill Australia New Zealand

Are Share Prices Too Volatile?

Published 22 May 2020

By Dr Peter J Phillips, Associate Professor (Finance & Banking) University of Southern Queensland

Are Share Prices Too Volatile? -- McGraw Hill ANZ Finance Blog -- Australia and New Zealand

When I first started reading the finance literature, one of the first themes I came across was the idea of efficient markets. This is not surprising because this idea dominated the literature for at least twenty years following the publication Eugene Fama’s famous 1970 review article. Even now, it continues to shape ideas in finance.

Efficient markets is a strange idea that actually has a number of different interpretations. Ultimately, however, it boils down to saying that a share’s price must be such that the expected return on that share is commensurate with the risk. In essence, prices are such that risk and reward are in equilibrium. When prices and returns get bumped out of equilibrium, they quickly adjust.

This is a powerful idea and has probably shaped everyone’s life. For example, if markets always adjust to equilibrium then we don’t need much regulation of them. Does this sound like a familiar policy position? It should because it has been an influential policy position for much of the last forty years.

There is a counter-idea. Broadly, this counter-idea is called behavioural finance. That is, the set of theories and findings that refer to the quirky ways in which investors make decisions. An early contributor to this alternative perspective to efficient markets was Robert Shiller. He argues that share prices are influenced by human psychology more than information and that prices can drift a long way from equilibrium and stay there. Although Shiller has written widely on this topic, his early work on ‘variance bounds’ caught my attention.

One of the early interpretations of efficient markets associated the idea with the dividend discount model. That is, in an efficient market, prices would always be equal to the present value of future dividends (we display this model in Chapter 6, equation 6.8 of Financial Institutions, Instruments and Markets 9e). Shiller recognised a potential problem. He asked, “If share prices are determined by investors’ estimates of future dividends and dividends don’t swing wildly up and down (which they don’t), why do share prices move so much?” To make his point, he plotted share prices against the present value of dividends to show just how much share prices move relative to the one thing that is supposed to determine their movements. The paper containing this graph was Shiller’s (1980) Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends? He concluded that there must be something else at play. He has spent much of the last four decades trying to show how this ‘something’ is human psychology and emotion.

When the Nobel Prize in Economic Sciences was awarded in 2013, the committee could not split these two influential scholars. The 2013 Prize was shared by Fama and Shiller (along with Lars Peter Hansen). This is quite fitting. Both ideas have been very influential. And the struggle between ideas is far from over!

Discussion Question

Ask an investor about one of their recent decisions. What did they consider before making the decision? Dividends and other fundamental factors or did they make a decision based on tips or feelings?

Further Reading

Share pricing, including the dividend models, are discussed further in Chapter 6 of Financial Institutions, Instruments and Markets 9e. If you read the section, just think about the deeper implications.