Why the Stock Market is 19 Times More Volatile than It Should Be

By Josh Levine,  April 26, 2012, 10:58:59 AM EDT

By Josh Levine
Editor, MicroCap Investor

The quarterly letter by GMO's Jeremy Grantham is required reading for The Street because of his valuable insights on the big picture. In his latest he explains why the stock market is 19 times more volatile than it should be. Interestingly, the motivating force behind this craziness is the propensity of Wall Streeters to cover their asses.

“The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples' money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority, either completely or partially, 'go with the flow'. This creates herding, or momentum, which drives prices far above or far below fair price.

“…It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in 'fair value' for the stock market. This difference is massive - two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1% of its long-term trend...

“The market's actual price - brought to us by the workings of wild and wooly individuals - is within plus or minus 19% two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines!




The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.


This article appears in: News Headlines, US Markets, Investing Ideas, Stocks

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