Thursday, March 7, 2013

7/3/2013: Are stocks more volatile in the long run?

A recent paper by Lubos Pastor and Robert F. Stambaugh, titled Are Stocks Really Less Volatile in the Long Run? (first published NBER Working Paper Series No. 14757; Cambridge: National Bureau of Economic Research, 2009.) and subsequently in the Journal of Finance (vol 67, number 2, April 2012, pages 431-477) looks at the annualized returns volatility to stocks returns - the central concern for investors and finance practitioners. 

The study uses predictive variance approach to the analysis of volatility and look at what happens to predictive variance as the investment horizon increases. Conditional variance is variance in returns conditioned on the set of information known to investors.The predictive variance is therefore the conditional variance, where conditioning information is taken at the time when investors make their assessment of the risks (volatility) and returns implied by an instrument. 

Now, it is commonly established that stock returns volatility per any given period falls over the longer periods, potentially due to mean reversion, as majority of the studies show or argue. But this only relates to volatility as measured concurrently - in other words unconditionally. Of course, investors face volatility as expected on the basis of conditioning variables, and this predictive variance, it turns out, actually is higher, not lower, over the long periods. The study shows that this reversal of the relationship between investment duration and volatility of returns holds even once we control for mean reversion. In other words, uncertainty about future expected returns is a core driver of higher long-horizon variance in stocks.

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