Investment Risk and Stock Prices

By November 1, 2018 Blog
            Academics and practitioners alike recognize that increase in the perceived risk of equity investing, and the associated increase in the risk premium, can cause stock prices to fall.  Most of the measures of risk are abstract like the historical standard deviation of stock returns or the future implied volatility of returns as measured by the VIX.  There is one more basic measure that I believe has a more visceral impact, the frequency of large drops, defined as 1% or more, in widely reported stock indexes.  When sharp price drops occur not only do investors lose money, but the decline is big news in the financial press.  Pundits weigh in with explanations for the drop and worry about whether further declines are likely.  If several drops occur in close proximity, the impact is multiplied. 
            For the foregoing reasons, I like to track the frequency of 1% drops.  In the year from October 1, 2016 through September 30, 2017, for example, there were only 5 drops of 1% or more.  Furthermore, they were widely dispersed and typically followed by immediate recoveries.  Such a low rate of large drops was well below historical averages and, no doubt, conveyed an impression of quiescent times.  In October 2018, the situation was dramatically different.  There were 5 drops of 1% or more in that month alone – a rate 12 times that of the past year.  Not surprisingly, the financial press was filled with stories about the increased risk of stock investing along with a host of explanations for the drops.  From my perspective many of the explanations are speculative at best, but tracking the frequency of large drops is a recommended exercise nonetheless.

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