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According to asset pricing theory, stock prices are equal to the expected value of discounted dividends. As a result, stock price volatility results from either dividend volatility or time-variation in the discount rate used to compute the net present value of dividends.

The original puzzle in financial economics was why stock prices are so volatile relative to dividends. According to the Gordon growth formula, stock prices and dividends should have the same volatility. In the data, however, stock prices are significantly more volatile than dividends. Since the 1950s, stock prices have exhibited 16 percent annualized volatility. That is almost 10 percentage points higher than the “fundamental” volatility of dividends, which has been closer to 7 percent (for example, see Shiller’s annual data).

Today’s realized volatility is about 6-7 percent. This level is what one would have originally predicted using the Gordon growth formula, suggesting that the low volatility puzzle is perhaps less puzzling than originally thought.