Why Did Individual Stocks Become More Volatile

The fact that stocks become more volatile on average is documented by Campbell et al (2001) and Morck et al (2000) for the U.S. since 1960s. In this paper, we investigate why individual stocks become more volatile. Our inquiry focuses on the 1976-2000 period during which quarterly accounting data are available at the ...rm level. We report that corporate earnings have deteriorated on average and their volatility has increased over the sample period. This is more evident for newly listed stocks than for existing stocks. The stock return volatility is negatively related to the return-on-equity (scaled earnings) and positively related to the volatility of the return-on-equity in cross-sections. The downward trend in the return-on-equity and the upward trend in the volatility of the return-on-equity account for a major component in the upward trend in average stock return volatility. The relationship between risk and returns plays an important role in the asset pricing literature. It has long been recognized that both expected return and volatility change over time. Sophisticated econometric models such as GARCH have been developed to characterize the volatility behavior of asset returns. These models assume that conditional volatility of future returns depends on shocks in the current volatility or other state variables, while unconditional volatility is constant over time. It is therefore a surprise that in a recent paper by Campbell et al (2001), the level of average stock return volatility is found to have been increasing over time from 1962 to 1997 in the U.S. Moreover, it is the idiosyncratic stock return volatility that has increased over time, while the volatility of the stock market returns remained basically unchanged. The latter ...nding echoes another related work by Morck et al (2000) in which the rise of the ratio of idiosyncratic risk to systematic risk in the US stock markets is documented. That the average stock return volatility has been increasing has some profound implications for investors because, as Campbell et al (2001) point out, investors may not always be able to fully diversify their investment portfolios and increased idiosyncratic risks corrode the risk-reward relationship. In order to understand better the causes and consequences of the increasing stock market volatility, a brief review of the larger literature on the so-called excessive volatility is worthwhile. Shiller (1981) argues that volatility in the stock market index is too high to be accounted for by the variation in subsequent dividends.1 A similar phenomenon is also found in the bond market. Roll (1988) examines the relationship at the ...rm level between corporate events and the stock returns immediately after the events and ...nds a very low R. The evidence seems to suggest that stock returns are unrelated to the changes in their fundamental values. There is a literature that documents a positive relationship between stock return volatility and trading volume. In a follow-up study to Campbell et al (2001), Malkiel and Xu (2002) suggest that increased volatility 1The issue is clouded by the possibility that corporate managers intentionally smooth dividend payments (Marsh and Merton 1986) and by the assumption used by Shiller that the discount rate for future dividends is a constant (Cochrane 1992).