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Should Investors Fear Market Volatility?

With company cash flows hard to forecast, volatile share prices are a rational response to stock market risk and uncertainty

Alex Bryan 04.09.2018

Stock market volatility

Investors often overreact to macroeconomic news, not properly evaluating their impact on a company’s future cash flows, which can create opportunities for value investors. Nobel Laureate Robert Shiller made a similar argument that market prices are more volatile than they should be, based on changes in future dividends.

While the market probably doesn’t always get prices right, a look at historical earnings suggests that the volatility in share prices is justified on average. A share’s intrinsic value is the present value of its future cash flows plus whatever assets it has minus liabilities. These cash flows are risky because they represent the cash that is left over at each firm after all the bills are paid. Given the large impact of cash flows on fundamental value, it might seem like stock prices should be roughly as volatile as their firms’ cash flows. But investors don’t know what those cash flows will be ahead of time and that uncertainty is a source of added volatility.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA is the Director of Passive Fund Research with Morningstar.

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