VOLATILITY PUZZLE

Aayush Grover | Aryamman Jani | Bhavya Sood

The Volatility Puzzle
A phenomenon where stock prices and other financial assets are observed to be more volatile than can be
explained by standard economic models.
Violates the Traditional Finance Theory - The volatility of asset prices should be proportionate to the risk involved in
holding the asset.

Traditional models Financial markets Market participants

do not fully capture are not perfectly may have different
the complex efficient, meaning views on the future
behavior of market that prices may not prospects of an asset,
participants. always reflect all leading to a wide
available range of opinions and
information. higher volatility.

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Higher Risk Doesn’t Mean Higher Return
Lower beta portfolios outperform the higher beta portfolios over the long term

Growth of 1$ invested in
1968

Bottom Top
Quintile Quintile
60.4$ 3.77$

Inflation Inflation
Adjusted Adjusted
10$ 0.64$

Inflation Impact

1968 2008
1$ 0.17$

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Higher Risk Doesn’t Mean Higher Return
Lower volatility portfolios outperform the higher volatility portfolios over the long term

Growth of 1$ invested in
1968

Bottom Top
Quintile Quintile
59.5$ 0.58$

Inflation Inflation
Adjusted Adjusted
10$ 0.1$

Inflation Impact

1968 2008
1$ 0.17$

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Heterogeneous Agents
Agents who differ in terms of their objectives, abilities, capacities, and interests.

Classification of Investors

Risk Preference

Time Horizon Investment Constraints

Retail vs Institutional Access to Information

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Financial Frictions
It refers to the barriers that can limit the flow of credit and investment in financial markets.

Effects on Financial markets

Credit Constraints

Asymmetric Information

Liquidity Constraints

Regulatory Restrictions

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Information Asymmetry

Meet Mr. Arihant who is currently on a

drive to sell his car to any one of the
potential buyers

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Anchoring Bias
Anchoring bias is a cognitive bias that explains the human tendency to base a decision on a particular piece of
data or anchor.

Mr. Sarthak Bindal

An avid investor

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Anchoring Bias
Anchoring bias is a cognitive bias that explains the human tendency to base a decision on a particular piece of
data or anchor.

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Anchoring Bias
Anchoring bias is a cognitive bias that explains the human tendency to base a decision on a particular piece of
data or anchor.

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Anchoring Bias
Anchoring bias is a cognitive bias that explains the human tendency to base a decision on a particular piece of
data or anchor.

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

The Curious Case of Rich People
The Problem Presented is one of Vital Importance….

OPTION A
He does not have a girlfriend

Come up with a strategy to solve

Siddharth Garg wants to OPTION B this problem.
go to Amit Trivedi’s He does have permission
Concert with his GF. from parents

THE SITUATION THE COMPLICATION THE QUESTION

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Mood and Sentiment
Sentiment impacts stock market and is even used as a predictor for returns and volatility

One example is a study published in the Journal of Financial Economics in 2001 by Malcolm Baker
and Jeffrey Wurgler. The study found that the sentiment of individual investors, as measured by
surveys and trading patterns, could predict short-term stock returns and volatility.
The study also found that periods of high sentiment tended to be followed by lower returns and
higher volatility

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Question’s that matter…

In all low-income countries across the world today,

how many girls finish primary school?

20% 40% 60%

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Question’s that matter…

How many of the world’s 1-year-old children today

have been vaccinated against some disease?

20% 50% 80%

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Question’s that matter…

Global climate experts believe that, over the next

100 years, the average temperature will...

Gets Remains Stays

warmer Same Cold

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Question’s that matter…

In the last 20 years, the proportion of the world

population living in extreme poverty has

Doubled Halved Remained the Same

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

Overconfidence
In the present market too, we have data to prove that overconfidence is leading to higher volatility

Overconfident investors tend to trade more frequently, which leads to higher market volatility.
- Terrance Odean and Brad Barber

Overconfident traders are trading more frequently and generating sub-par returns

Individual investors tend to be Average holding Period for them Underperform the market -
overconfident in their own is 3.1 years as opposed to 5.9 Morningstar
investment skills years for institutional investors
- University of California, Berkeley

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

I wanted to increase the number of slides I was covering

Word Rating
Apple
Bicycle
Coffee
Diamond
Elephant
Flower
Guitar
Honey
Island
Jupiter

Volatility Puzzle Empirical Data Non-Behavioral Behavioral Factors Conclusion

THANK YOU