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09/17/2015

Decomposition of Total Volatility: How Important is Idiosyncratic Risk?


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Introduction

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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-Indrani De, CFA, PRM and Joshua Nutman

Indrani De, CFA, PRM, is Sr Director of Quantitative Research at investment firm New Amsterdam Partners LLC. She received an undergraduate degree in Economics (Honors) from University of Delhi, an MBA from the Indian Institute of Management (Bangalore), and completed the coursework for a PhD (Business-Major in Finance) at the City University of New York. She has been published in the Journal of Investing, Journal of Investment Consulting and NYSSA Financial Professionals’ Post. Indrani is the Past President of the Society of Quantitative Analysts (SQA). She has been a speaker multiple times at industry conferences like Thomson Reuters, QWAFAFEW,  CFA, PRMIA, Derivatives USA, TOIGO Foundation, and been extensively quoted in various media outlets including Reuters, Forbes, IR, FinAlternative and many more.

Joshua Nutman graduated with first class honors in Physics from the University of London. He works at BlackRock and interned at New Amsterdam Partners LLC.

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