Why Are Financial Markets So Volatile?

The pandemic first hit and spread through 2020, and the stock markets of Japan, the European Union, Japan, and the United States plummeted to 30 per cent. The effects of the virus on public health, the global economy, and myriad aspects of daily life were unclear and even extremely dangerous. The magnitude of these markets' reactions was a mystery for financial analysts. "For the market to drop by 30 percent just because of revised growth expectations, the impact on future dividends must be substantial and persistent," wrote Chicago Booth's Niels Gormsen and Ralph S. J. Koijen that fall. "It could be to say, for instance, that it is not consistent with a recovery that is V-shaped." 

The stock market was unstable, sure, but they were also acting more volatile than can be attributed to the fundamentals underlying them. There have also been extreme volatility, such as the stock price run-ups at video game retailer GameStop and movie theatre chain AMC. The dynamic applies to other kinds of markets, too. A single bitcoin does not have future cash flow or earnings, so it is insignificant according to the traditional model. Therefore, why would anyone pay thousands of dollars to buy one? That's why their value should fluctuate so dramatically due to the tweet of the billionaire Elon Musk. The traditional wisdom, as embodied in the efficient market hypothesis, states that market prices reflect the asset's fundamental value. But more and more, research reveals another critical factor: investors' demands that could or may not be well informed. The Chicago Booth's Samuel Hartzmark and Boston College's David H. Solomon, through an analysis that covers data from 1926 through 2020, found that the stock market was prone to increase more on days that saw higher dividend payouts when investors took the cash that was deposited in into their account and reinvested it into the market. (For more information, see "Dividend dividends cause stock price rises.") "There's nothing to suggest that why we should observe the same thing as we do," Hartzmark says, or unless it's the case that conventional wisdom was either wrong or not recognizing something.  The Harvard's the Xavier G. Gabaix and Booth's Ralph. J. Koijen are among the people who believe it. Their inelastic market hypothesis HTML0lays a case for why financial models must incorporate the long-ignored effects of demand and supply. They estimate that each $1 that enters the market increases prices by $5, and these forces increase volatility, which is why stock returns are over double what the essential information suggests they should be. 

The core of their argument is a new definition of the stock market that has been transformed over the last several years by the rise of index funds and other big, slow-moving investors.  "What we're suggesting is that a significant portion of markets are controlled by mandates and is not necessarily responding to any new information. And , in certain instances investors might be having difficulty understanding the expected return and, therefore, they're also not relying much on price," says Koijen. With so much cash lying in limbo, the prices are more receptive to the events in trading. "As as a result, sudden changes to investor demand and flows can have a significant impact on prices, resulting in unstable markets."