When Are Stocks Less Volatile in the Long Run?

Pastor and Stambaugh (2012) find that from a forward-looking perspective, stocks are more volatile in the long run than they are in the short run. We demonstrate that when the nonnegative equity premium (NEP) condition is imposed on predictive regressions, stocks are in fact less volatile in the long run, even after taking estimation risk and uncertainties into account. The reason is that the NEP provides an additional parameter identification condition and prior information for future returns. Combined with the mean reversion of stock returns, this condition substantially reduces uncertainty on future returns and leads to lower long-run predictive variance.

Automated summary

The study demonstrates that stocks are less volatile in the long run when the nonnegative equity premium (NEP) condition is imposed on predictive regressions, even after considering estimation risk and uncertainties. This is because the NEP provides additional parameter identification conditions and prior information for future returns, which, combined with mean reversion of stock returns, significantly reduces uncertainty and leads to lower long-run predictive variance.