Risk Latte - Volatility and the Irrational Man

Volatility and the Irrational Man

Rahul Bhattacharya
May 31, 2006

Every man is a rational animal. Robert Merton is rational, John Meriwether is rational, Myron Scholes is rational, and so are all those thousands of Wall Street investors and traders. I am rational too, because I think Black-Scholes-Merton equation is the holy grail and I make a living out of telling people the virtues of Markowitz's efficient frontier. But, there is one irrational man-Robert Shiller (actually, there could be one more, Nassim Taleb).

In 1981, in a seminal paper titled "Do Stock Price Move too much to be Justified by subsequent changes in Dividends?" published in the American Economic Review, this man literally put the existing rational markets hypothesis (a cousin of Efficient Markets Theory) of finance stand on its head. In many ways, as Taleb notes in Fooled by Randomness, "This 1981 paper may be the first mathematically formulated introspection on the manner in which society in general handles information".

His argument was with respect to the volatility of markets (read equities). He argued that if the price of a stock which depends on something "fundamental" (e.g. discounted cash flows, dividends, etc.) then the stock prices are far too volatility as compared to the tangible manifestation of that fundamental value. In other words, he was arguing, in 1981 (mind you this was a good two decades before the dot com frenzy), that the stock prices swing much more than the underlying fundamentals that they are supposed to represent.

In the early eighties the profession of Economics, more importantly financial economics was ruled by the rational expectations hypothesis and the efficient markets theory of Markowitz. By then Markowitz had already become a legend and Sharpe, Black, Scholes and Merton were the rising stars on Wall Street and traders and investors were intoxicated with the notion of a "rational man", "security market line", "efficient frontier" and "synthetic arbitrage free portfolios". So people wondered: who is this guy talking all nonsense that the volatility of the (US) stock market was greater than could be explained by any rational analysis of the future?

But Shiller was resolute. The prices of stocks most of the times overreact and they are either too high or too low as compared to the underlying fundamentals of the corporation.. And this is because investors at the end of the day are not rational but emotional. It is the collective emotions of all investors, driven by the availability of imperfect information, that ultimately determines the prices of equities. As Taleb explains Shiller's proposition the volatility differential between prices and information meant that something about "rational expectation" did not work . Shiller pronounced the markets to be inefficient and that volatility is a function of information flow only.

Practically every one of any standing criticized Shiller. The principal criticism against Shiller came from Robert C Merton (of the famous trio of Black-Scholes-Merton). But we will go no further in that direction. Suffice it to say that these days, every time someone goes in front of a stock trading screen or tunes in to their favourite financial news channel listen to the horseshit about stock market volatility, VIX, commodity prices or Gold, we should invoke the name of Robert Shiller.

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