Law of total variance and volatility tests

For any two random variables X and Y , we find

Var(X) = E(Var(X|Y )) + Var(E(X|Y )).

Proof.

Var(X) = E(X 2 ) − E(X)2

= E(E(X 2 |Y )) − E(E(X|Y ))2
= E(Var(X|Y ) + E(X|Y )2 ) − E(E(X|Y ))2
= E(Var(X|Y )) + (E(E(X|Y )2 ) − E(E(X|Y ))2 )
= E(Var(X|Y )) + Var(E(X|Y ))

Since variances are always non-negative, the law of total variance implies

Var(X) ≥ Var(E(X|Y )).

Defining X as the sum over discounted future dividends and Y as a list of

all information at time t yields
∞
! ∞
!!
X dt+i X dt+i
Var i
≥ Var Et i
.
i=1
(1 + ρ) i=1
(1 + ρ)

If the price of a stock is just the expected sum over future discounted divi-
dends
∞
!
X dt+i
Pt = Et
i=1
(1 + ρ)i
(i.e. if there is no bubble), this would imply that
∞
!
X dt+i
Var ≥ Var (Pt ) .
i=1
(1 + ρ)i

If the time series on both sides of the inequality are stationary and ergodic,
we can use observations at different t to estimate both variances and test
the prediction. (We would have to truncate the infinite sum at some t + k,
k large, but this is arguably justified, since the (remote) future is (heavily)
discounted and hardly influences the infinite sum.)