What causes share price volatility? New research adds something else to the many possible explanations – the level of share prices themselves.
Kelly Shue at Yale University and Richard Townsend at the University of California at San Diego show that lowly priced shares have volatilities and betas that are “significantly higher” than those of higher-priced stocks. This is true even controlling for things that might affect volatility such as companies’ size, debt and valuations. They estimate that if the price of one share is half that of an otherwise comparable one, its volatility and beta are around 20 per cent higher.
What’s more, they show that after a stock split – something that reduces a share’s price without affecting anything else – volatility and beta rise. This too is consistent with price alone being a cause of volatility.
This, they say, is because investors are prone to a form of money illusion. They believe that a particular piece of good news should cause a rise in price not just in proportional terms but in absolute ones. And obviously if you think “this news will add 10p to a share’s price” lower-priced stocks will rise more than higher-priced ones, and by the same token fall more in response to bad news.
You might think that if low-priced shares are more volatile than high-priced ones they should offer higher returns to compensate for this. They don’t. Vijay Singal at Virginia Tech and Jitendra Tayal at Ohio University show that the opposite has been the case. They estimate that in the US 10 per cent of stocks with the highest prices outperformed the 10 per cent with the lowest by an average of 4.3 per cent per year between 1962 and 2013. Researchers at the University of Bremen have found a similar thing to be true in Germany. This is yet more evidence – such as the outperformance of defensive stocks and underperformance of distressed and speculative ones – that there is often no trade-off between risk and return.
All this suggests investors should be especially wary of lower-priced stocks: on average they offer more risk but less return.
It has, however, a wider message. This is evidence that shares’ behaviour can be influenced by factors that are strictly speaking irrational. What’s more, there’s not much that more sensible investors can do to exploit or eliminate this irrationality.
