In their October 2003 paper entitled “Determinants of Stock Market Volatility and Risk Premia”, Mordecai Kurz, Hehui Jin and Maurizio Motolese model and examine “the dynamics of diverse [but still rational] beliefs” as the driver of asset market volatility. Specifically, they postulate that:
- It is unreasonable to assume that investors in a complex, dynamic economy will exhibit all-knowing rationality. Rather, rational investors hold beliefs generally compatible with, and forecasts not disprovable by, available empirical data. This level of rationality accommodates considerable diversity of beliefs among equally informed investors.
- A bull expects returns on investments to be higher than the norm of past returns; a bear, lower. To maintain rationality as new data becomes available, bulls and bears must change their beliefs over time.
- The aggregate “market state of belief” across all investors determines the asset risk premium, and the dynamics of this state of belief drive price volatility.
By modeling and exploring this conceptual framework, the authors conclude that:
- Overconfidence intensifies investor expectations, thereby inducing high price volatility. Refer to investor discussion boards, market analyst forecasts and business press commentaries for examples of overconfidence and intensity.
- Investors are bearish (expecting lower than normal returns) more than 50% of the time. Consequently, when bullish, they expect large excess returns over relatively short periods. This asymmetry reflects the fact that major stock market advances occur relatively quickly following market declines.
The authors note that while these two conclusions “can be satisfied by different belief formation models, the simplest way to think of them is as an expression of animal spirits.” Perhaps overconfidence compensates for the paralyzing effect of uncertainty. Perhaps a predominant pessimism fuels preparation and risk management.
In summary, investor emotions drive market volatility, but there is an asymmetry to fear and greed.
