Wild Ride

Based on research Gustavo Grullon, James P. Weston, Jason Fink and Kristin E. Fink

• A higher proportion of younger firms and a dramatic increase in firm listings caused wild fluctuations in stock prices during the Internet boom.
• This might not have represented a decrease in market quality.
• Lower investment costs for young firms could represent an efficient mechanism for capital allocation, risk sharing and social welfare.

The 1990s were exciting years for people investing in stocks. Geeks and innovators in West Coast dorm rooms and garages constantly introduced new technology to the market. East Coast traders, investors and soon everyone plugged into finance took note, as the Internet became a household commodity.

While the high-tech industry boomed, the stock market saw a huge spike in volatility. But most researchers now agree that the spike was not caused by inflated market prices. Rather, firm-specific risk, or idiosyncratic volatility, increased. In other words, a vast number of companies, introducing a range of products and services while promising future growth and returns, simply made for less certain investments.

But what, specifically, drove this market-wide fluctuation during the boom remains open to debate. Gustavo Grullon and James P. Weston, professors at Rice Business, and a team of collaborators examined this issue.

Some researchers have linked the greater volatility to changes in fundamental characteristics of public firms, such as a firm’s size or a high rate of capital expenditures relative to tangible assets.

The researchers found that systemic changes in firm fundamentals indeed contributed to one of the largest spikes in idiosyncratic volatility in U.S. history. At the same time, they argue, these changes do not speak to a longer-term trend.

Other researchers have argued that firm-specific risk rose due to the irrational behavior of traders changing “sentiment.” Testing for sentiment as a driver, Grullon, Weston and their collaborators found that investor sentiment incontestably correlated with idiosyncratic volatility.

When compared to a firm’s age, however, investor sentiment either lost its statistical significance or related negatively to idiosyncratic risk. After considering a range of alternative arguments in their analysis, the researchers weren’t completely satisfied. Perhaps, they speculated, the spike in idiosyncratic volatility was due to a market-wide decline in firm maturity and the large increase in initial public offerings. After all, the ratio of equity market capitalization represented by young firms peaked in the late 1990s. And a large number of young firms dependent on future cash flow can influence idiosyncratic risk across markets.

By evaluating over 94 percent of the total market capitalization in the United States between the years 1926 and 2006, Grullon and Weston tested idiosyncratic risk. Controlling for characteristics related to a firm’s age, they found little evidence of an abnormal spike in idiosyncratic volatility during the Internet boom.

Instead, they found, firm characteristics such as age, as well as fundamentals such as size, profit margins and tangible assets, gave way to greater uncertainty about future profitability. It was this dynamic, the researchers concluded, that drove the rise in market-wide idiosyncratic risk. And it might not have been a bad thing.

In general, American capital markets have shown an increasing willingness to buy firm equity claims at earlier stages in an enterprise’s life cycle. If a shift in supply results in a higher proportion of younger firms, this might represent a decline in the cost of equity capital for young firms. Lower costs for investing in young firms could represent an efficient mechanism for capital allocation, risk sharing and social welfare.

Gustavo Grullon is a Jesse H. Jones Professor of Finance

James P. Weston is the Harmon Whittington Professor of finance at Jones Graduate School of Business at Rice University

To learn more, please see: Fink, J., Fink, K. E., Grullon, G., & Weston, J. P. (2010). What drove the increase in idiosyncratic volatility during the Internet boom? Journal of Financial and Quantitative Analysis, 45(5), 1253-1278.