Decomposition Of Total Volatility: How Important Is Idiosyncratic Risk? Indrani De, CFA, PRM and Joshua Nutman by The Finance Professionals’ Post
In recent years there has been a lot of debate about volatility, and the components of volatility. A lot has been said about the risk-on, risk-off market with a focus on macro and factor risks. There are many dimensions to volatility, and this paper uses the methodology of Campbell et al. (2001) to break down the total volatility in US equities into the three components of Market, Industry and Firm (idiosyncratic risk), and analyzes the trends in their share over time. We look at the time period January 2005 through December 2014, incorporating the years prior to, during and post financial crisis, and use S&P 500 as a proxy for the US equities, with the Global Industry Classification Standard (GICs) sector classification. The main conclusion is that there is a strong payoff to stock selection even in the post-financial crisis era where market participants often think of risk only in terms of risk-on and risk-off. The share of idiosyncratic risk indicating benefits of stock selection decreased a lot during the crisis. It is now at the highest level since the start of the financial crisis, though still much lower than in the pre-crisis years.
Active stock selection can make the greatest contribution when idiosyncratic risk becomes a bigger component of total volatility. Campbell et al. (2001) laid out some important reasons for decomposing aggregate volatility into its sub-components of market, industry and firm. Aggregate volatility, important in any theory of risk and return, is the volatility experienced by holders of aggregate index funds. But aggregate market return is only one component of an individual stock’s return, with industry-level and idiosyncratic firm-level shocks being two other important components. Some reasons to be interested in volatility of the sub-components include holding portfolios that may not be diversified enough, or arbitrageurs trading stock mispricings facing risks related to idiosyncratic volatility. The optimum number of portfolio holdings needed to make it well-diversified is itself a function of the level of idiosyncratic risk.
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Campbell et al. (2001) used the daily returns of all stocks listed on CRSP database and their main finding was that over the period 1962-1997, market and industry variances remained fairly stable. Firm-level variance displayed a large positive trend and more than doubled, leading to a noticeable increase in firm-level volatility relative to market volatility. Correlations among individual stocks and the explanatory power of the market model for a typical stock declined. All these indicated an enormous role for active stock pickers. De and Staniczenko (2006) analyzed the time period 1985-2005 and used the monthly returns for a much smaller sample of Dow Jones Composite Index (DJ65), and found similar results, indicating a further increase in the share of firm-level variance or idiosyncratic risk, while market risk decreased further and industry risk remained fairly constant.
Market participants are fairly unanimous that the financial crisis of 2008-2009 had a drastic impact on aggregate risk and its sub-components. This study was an attempt to understand the importance of idiosyncratic risk and therefore potential pay-offs to stock selection in current market conditions. We conducted the study from January 2005 through December 2014 using monthly returns of the S&P 500, and the results of this study are relevant in current market conditions.
We found total volatility increased ~4X during the crisis and is now lower than pre-crisis. Idiosyncratic volatility remains the largest component (> 60%) of total volatility for an equity investor. Over the last decade it declined from 70%-75% level in late-1990s, dipped sharply during the crisis, but remains the major component. The share of market volatility increased ~4X during the crisis to become the largest component. Currently much lower, it still remains 2X prior-recession average and higher than the long-term average. Sector volatility has shown a consistent decrease over 2005-2014, and is now the smallest share of total volatility.
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