How Do Stock Returns Behave and What Are the Implications for Me as an Investor?
Academic researchers and market practitioners have long sought to predict future stock return paths. One area of focus in such research has been the obvious question: what do we know about the behavior of past stock return paths?
Over many time periods, across many securities, and after many studies, researchers have identified several common empirically observed historical behaviors of past stock return paths. Researchers commonly refer to these widely observed behaviors as “stylized facts.”
If reading through this sample of observed statistical behaviors causes your eyes to glaze over, you can skip the details and know that there are two key take-aways here:
(1) The paths of past stock returns are subject to the never-ending statistical review of experts. Taking advantage of past information remains an ever-evolving challenge.
(2) There is at least one common pattern suggested by the data: stock return paths remain driven by powerful human emotions. Investors often take too much risk because they fear missing out on the upside, or they wait too long on the sidelines because they fear large, unexpected losses.
We believe a fiduciary advisor can be a powerful ally in helping you overcome either of these behaviors. We work with our clients to craft a personalized investment plan and subsequently coach them through the different market conditions they will face over time.
Without further ado, here are a few of these stylized facts and their implications for you as an investor:
| Observed Statistical Behavior | Practical Implication | Image |
|---|---|---|
| There is an absence of short-term linear correlation between different points in time in the paths of stock returns. This observation is commonly expressed as: recent past returns cannot be used to predict future returns. Researchers have struggled finding exploitable historical patterns over short-term (<3 months) stock return paths. The longer-term picture (+3 months) is more complex. | Be extremely cautious about making an investment decision solely based upon the recent path of a stock. |  |
| The volatility of stock returns is not constant over time. And in fact, unlike stock returns themselves, the volatility of stock returns exhibits predictability. This means large price changes tend to cluster together, as do small price changes. A calm market today is more likely to be calm tomorrow, and a turbulent market today is more likely to continue to be turbulent. Think of this phenomenon like a basketball player who goes on hot and cold shooting streaks. | Know that stock market risk is not constant, rather it comes in seasons. Knowing that stock market seasons are the norm (both calm and turbulent) can encourage an investor to stick to their long-term plan. Don’t ignore portfolio fortification in the midst of a calm sea and don’t panic in the midst of a storm. |  |
| The volatility of stock returns exhibit asymmetric patterns with respect to time. In other words, a time series of stock return volatilities is not the same when viewed forward in time as when viewed backward in time. Time irreversibility in the pattern of volatility suggests non-linear dynamics. This phenomenon is often called “the leverage effect” because it is thought it may arise from the impact of companies carrying debt on their balance sheets. The impact on stock return paths is that a stock price drop increases future volatility more than a price increase of the same magnitude decreases future volatility. | The worst days are going to be more volatile than the best days. Have a long-term plan that prevents you from being a forced seller after large declines in price. |  |
| Stock returns are not normally distributed. Even accounting for the previously mentioned “leverage effect”, stock returns have fatter “tails” than a normal distribution. This means extreme price movements are much more likely than a normal distribution would predict. Researchers often model such movements as discontinuous “jumps” in prices (sometimes up, sometimes down). For example, imagine the jumps in stock price movements that might result from sudden, unexpected yet impactful news events. | Extreme market movements can happen suddenly and without warning, and they are a fundamental source of risk that cannot be eliminated. Shy away from “experts” who suggest they can predict specific jumps ahead of time; if jumps could be successfully predicted, they would likely not exist in the historical record. |  |
| The returns of an aggregated group of stocks (like the S&P 500) exhibit negative skewness. This means the distribution of aggregate stock market index returns is asymmetric: large negative returns occur more frequently than large positive ones, and there is a higher frequency of small positive returns than small negative returns. | The fact that stock market indexes have more positive trading days than negative ones can lull an investor into a false sense of security. Negative skewness is a reminder that the biggest risk of loss isn’t from frequent small daily fluctuations, but from rare, yet impactful downturns. |  |
| In the reverse of the skewness previously mentioned, the distribution of individual stock returns over time exhibits positive skewness. This means only a few individual stocks will exhibit huge gains, whereas most individual stocks will underperform the return of even a savings account. | Guard against stock picking behavior that mimics the behavior of the lottery ticket participant; investors dream about creating life-changing wealth as they search for the next “Amazon” or “Nvidia.” However, like lottery tickets, the probability of picking one of these few life-changing stocks is extremely low. |  |
| The correlation of return paths between stocks is less than one. When some stock returns zig, others zag. Two good stocks might perform well during different periods. | Because of the offsetting nature of different stock return paths, an investor can reduce the risk of their investments with limited sacrifice in return by owning a portfolio of stocks. |  |
| Researchers have observed that the correlation between two different stocks’ volatility is persistent. This means that if a high-volatility period occurs in one stock, it is more likely to expect a high-volatility period in another, related stock. In other words: volatility is often contagious. | While diversification is valuable, it is less effective during a crisis and not a failsafe against overall market declines. |  |
Before joining the firm in 2010, Andrew served as an investment consultant to the New York-based hedge fund Southpoint Capital Advisors, LP. Andrew’s previous work experience includes private equity and investment banking roles with Raymond James, Equity Group Investments, IPC Industries, and Chestnut Partners. Andrew graduated magna cum laude with a degree in economics from Harvard College, and received his MBA, with distinction, from Northwestern University’s Kellogg School of Management where he was chosen by faculty as the top finance student in his graduating class. Andrew taught courses in Advanced Financial Management and Money and Capital Markets as an Adjunct Lecturer at Spring Hill College. He is on the board of the McGill Toolen Foundation, a member of the Board of Trustees for the McCallie School, and is an active alumni volunteer for both Harvard and Northwestern. He enjoys keeping up with his four children’s extracurricular endeavors and traveling with his family.
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Important Disclosures: The statements and opinions expressed in this article are those of the authors as of the date of the article, are subject to rapid change as economic and market conditions dictate, and do not necessarily represent the views of Leavell Investment Management, Inc. This article does not constitute investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. Investing in securities carries risk including the possible loss of principal. Individual circumstances vary. Past performance is no guarantee of future results.
