Decomposition of Total Volatility: How Important Is Idiosyncratic Risk?

Abstract

In recent years there has been a lot of debate about volatility, the risk-on/risk-off market with a focus on macro and factor risks. Our research 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 2005-2014. The value addition from active stock selection is greater when idiosyncratic risk becomes a bigger component of total volatility. Our main conclusion is that there is a strong payoff to stock selection even in the post-financial crisis era where markets often think of risk only in terms of risk-on/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. Total volatility increased ~4X during the crisis and is now lower than pre-crisis. The share of idiosyncratic volatility dipped sharply during the crisis, but remains the largest component (> 60%) of total volatility for an equity investor. The share of market volatility increased ~4X during the crisis to become the largest component. Currently much lower, it is still 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. Average pair-wise stock correlation in the S&P 500 increased ~3X from pre-crisis years through 2010, and is now 2X pre-recession average. The power of the market model in explaining stock returns, increased sharply from 22% pre-crisis to more than 50% in 2010, and has since decreased and remained consistent at ~30%. We also found a strong negative correlation between all components of volatility and contemporaneous GDP growth, with the information decay being fastest for idiosyncratic volatility. Idiosyncratic risk as a share of total stock volatility, though lower than pre-crisis levels, is the highest since the financial crisis. It remains the largest share of total U.S. equity volatility providing a strong justification for stock selection and active management.