In the Classroom: Explaining the Volatility of the Aggregate Stock Market
Over the last century, the price-to-earnings ratio of the aggregate stock market has varied widely, from as low as 4 to as high as 40 or greater. What explains the volatility of this measure?
In the Behavioral Finance course earlier this year, Professor Nicholas Barberis considered a number of the standard explanations for this volatility, all of which presume that investors are acting rationally. For example, scholars have suggested that higher price-to-earnings ratios reflected a rational forecast of higher earnings.
This explanation, Barberis said, was shown to be wrong in a landmark paper written by Yale’s Robert Shiller in 1981, which demonstrated that there is no relationship between high price-to-earnings ratios and subsequent higher earnings.
“This study of Shiller’s really shocked the academic profession, because it showed that the framework that people had been using for decades to think about stock market fluctuations was simply wrong,” Baberis said. The paper, he noted, led to Shiller’s winning the Nobel Prize more than three decades later and, by suggesting that irrational factors contributed to market volatility, to the development of behavioral finance.
What might those irrational factors be? One possibility, Barberis said, is “over-extrapolation of past returns”—that is, investors incorrectly believing that a rising stock market is most likely to continue to rise.
Watch an excerpt from the lecture: