Chart 2 shows a measure of excess volatility in these series over time (a moving average of the ratio of actual to fundamentals-based volatility), while Chart 3 shows a measure of price misalignment (the absolute deviation of prices from fundamentals, expressed as a percentage of prices). Chart 2 suggests that, on average over the past century, US stock prices have been over three times more volatile than fundamentals, confirming the excess volatility hypothesis. But the trend in the degree of excess volatility is also telling. Up until the 1960s, prices were around twice as volatile as fundamentals. Since 1990, they have been anywhere between six and ten times more volatile. Excess volatility in equity prices has risen as financial innovation has taken off. The pattern is much the same with measures of misalignment. Up until 1960s, the average absolute deviation of US equity prices from fundamentals was just over 20%. Since 1990s, the average absolute deviation has been well over 100%. Charts 4–6 present the same evidence for UK equity prices since 1920. While less dramatic, the patterns are much the same. Misalignment correlates with innovation and liquidity. Patience and profits To bring these market inefficiencies to life, consider a simple experiment to gauge the relative performance of momentum and long-term investors. Both are assumed to follow a simple strategy: the speculator buys (sells) when prices have risen (fallen) in the previous period; the fundamentalist buys (sells) when prices are low (high) relative to fundamentals.
By 2009, that long-term investor’s stake would have risen to $ Over the same period, the momentum traders’ stake would have returned $ Buy-and-hold would have out-performed bought-and-sold by a factor of around 36. How different the world may have looked. Fundamentals would have triumphed over momentum. The sheep would have been herded by the goats. Facing a losing streak, speculators may have gone the same way as despairing Dick Fuld or the ravenous robin. The gene pool may have been cleansed of the impatient. Patience may have helped ward off great disaster, the like of which we have recently seen. Just as patience can ward off great disaster, impatience can ruin a whole life. Generations of dieters and addicts are testament to that. So too is finance, not least in the light of the crisis. It is important finance sticks to the patient evolutionary path. To do so, the fidgeting fingers of the invisible hand may need a steadying arm. 14  BIS Review 114/2010  Annex  BIS Review 114/2010  15  16  BIS Review 114/2010  BIS Review 114/2010  17  18  BIS Review 114/2010  References Ainslie, G and Haslam, N (1992), “Hyperbolic Discounting”, Choice Over Time, Russell Sage Foundation. Ainslie, G (1974), “Impulse control in pigeons” Journal of the Experimental Analysis of Behaviour 21(5). Angeletos, G, Laibson, D, Repetto, A, Tobacman, J and Weinberg, S (2001), “The Hyperbolic Consumption Model: Calibration, Simulation, and Empirical Evaluation”, Journal of Economic Perspectives 15(3), pp 47–68.