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News, noise and volatility

Created:

4 September 2009

Written by:

Chris Dillow

Because financial markets are volatile, correlations between things tend to be low, so strong relationships are hard to find. In this context, a discovery by Hans Bystrom of the University of Lund in Sweden is striking - that there's a huge correlation between stock market volatility and the volume of news.

He counted the number of stories about the stock market in Google News every day between August 2006 and last month. He found that, averaged over 30-day periods, the correlation between this measure of news and the volatility of MSCI's world market index was 0.82. By the standards of financial market correlations, this is enormous. It's also puzzling.

You might think it's not. Stuff happens. It moves prices. It gets reported. Simple.

No. Lots of news should, in theory, reduce volatility. Volatility arises from uncertainty. But information - by definition - reduces uncertainty. So, if news is information, there should be a negative relationship between it and volatility.

But there isn't. And it's not just Mr Bystrom who's found this. William Johnson at the University of North Carolina has found that the volatility of newly issued shares has been rising since the 1970s, as has the volume of news about such shares. And researchers at the University of North Carolina have found that it's only moderately good news that reduces volatility; bad news and really good news increases it.

One reason for this might be that some news does increase uncertainty - for example, that which takes the form "the probability of catastrophe is greater than you thought". A lot of the news we had in 2008 was of this sort.

There is, though, another possibility - that investors confuse news with mere noise. On seeing a news story they don't think "this is in the price by now", but rather feel they must do something. The result is that they trade not upon genuine information, but stale news. Classic papers by Brad DeLong of the University of California Berkeley, the late Fischer Black and Richard Roll of the UCLA Anderson School of Management have all shown how such noise trading increases volatility.

There's worse. It's not just news that generates volatility. Volatility also creates news, as big price moves cause newspapers to report more on the stock market - and such reports rarely take the form "noise trading has increased". This creates the possibility of a vicious circle; news generates excess volatility, which generates more news, leading to more excess volatility.

There's not much investors can do about this; As Insead's Bernard Dumas has shown, it's difficult to profit from excess volatility. What we can do, though, is ask of any piece of news: is this really worth trading on? Is it already in the price? And if it has sent prices lower, should I worry given that lower prices often mean higher expected returns? What do I know about this story that others don't?

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