Comparing Different Explanations of the Volatility Trend

We analyze the puzzling behavior of the volatility of individual stock returns over the past few decades. The literature has provided many different explanations to the trend in volatility and this paper tests the viability of the different explanations. Virtually all current theoretical arguments that are provided for the trend in the average level of volatility over time lend themselves to explanations about the difference in volatility levels between firms in the cross-section. We therefore focus separately on the crosssectional and time-series explanatory power of the different proxies. We fail to find a proxy that is able to explain both dimensions well. In particular, we find that Cao et al. (2008) market-to-book ratio tracks average volatility levels well, but has no crosssectional explanatory power. On the other hand, the low-price proxy suggested by Brandt et al. (2010) has much cross-sectional explanatory power, but has virtually no time-series explanatory power. We also find that the different proxies do not explain the trend in volatility in the period prior to 1995 (R-squared of virtually zero), but explain rather well the trend in volatility at the turn of the Millennium (1995-2005).