Why are stock and bond prices so volatile?
Many legitimate reasons come to mind but, perhaps, it is the one that doesn’t come to mind that might surprise you: mathematics.
Inherent in the calculation of stock and bond prices is an element of time. When it comes to investing, the mathematical term for time is duration. Simply put, duration is a measure of how long it takes you to get your money back.
Bond investors have long used an identifiable stream of cash flow, such as coupon payments, to calculate the duration of fixed-income investments. For example, the duration of a 30-year bond—one which pays interest every six months and repays principal almost three decades in the future—is approximately 14 years. This is because so much of the investment’s value is represented by interest payments, as compared to the discounted principal payment in the distant future.
Can the same calculation be applicable to stocks?
In a way, yes. Stock ownership represents a claim on a business’ future cash flows. This is not unlike the claim coupon holders have on future interest payments from a bond. Yet stocks, unlike bonds, have no maturity date. In principle, a stock’s cash flow can go on forever. Nevertheless, investors can reasonably infer the existence of equity durations.
The key is to assign bond-like characteristics to the stock. Thus, investors who want to calculate equity durations need to treat each dollar of earnings the same as bondholders treat each dollar of interest payments.
For example, a stock earning $1 and selling at $25 effectively yields 4 percent (1/25 = 4 percent). Dividing the yield into 100 (assuming 100 represents a complete return of invested principal) produces a duration of 25 years. Generally speaking, then, stocks can be considered long-duration investments, similar to long-dated zero coupon bonds (a bond that is sold at a deep discount rather than offering coupon interest payments), in that the prospective payoff for both of these types of securities is decades away.
What does duration tell us about the pricing of securities? As a general rule of thumb, the longer the duration, the greater the price volatility. For bonds, duration is used as a measure of an investment’s sensitivity to changes in interest rates. For example, if interest rates rise by 100 basis points, the current value of the previously mentioned 30-year bond will fall by about 14 percent. This is because as prevailing interest rates rise, newly issued bonds will offer a higher coupon rate, making existing bonds less attractive. In turn, the prices of existing bonds fall. Longer bonds, because they have more interest payments over their term, are therefore subject to the greatest price fluctuations. Even a small percentage change in interest rates can produce an outsized change in the price of the underlying security.
By comparison, stocks aren’t subject to the same interest rate risk as bonds; therefore, it is more useful to consider news events that tend to move stock prices. A common event-driven cause of stock price volatility is a change in earnings expectations by analysts or an announcement by a corporate management team offering guidance on the potential for their company’s future income stream. You see, in that a stock is essentially a very long duration investment, any change (or suggestion of change) to its future cash flow stream effectively produces a disproportionate change in today’s share price.
Therefore, when news events move the markets, investors should expect long-duration investments such as stocks to exhibit volatility far greater than bonds. It’s just math.
This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its
accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information
in this report does not pertain to any Van Kampen product and is not a solicitation for any product.
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