Time-Varying Risk and the Relation between Idiosyncratic Risk and Stock Return

Abstract

This paper studies the historical time-varying dynamics of risk for individual stocks in the U.S. market. Total risk of an individual stock is decomposed into two components, systematic risk and idiosyncratic risk, and both components are studied separately. We start from the historical trend in the magnitude of risk and then turn to the relation between idiosyncratic risk and stock returns. The result shows that both components of risk for individual stocks are changing over time. They increased from the 1960s to the 1990s/2000s and then declined until today. This paper also studies the risk-return tradeoff by investigating the relation between idiosyncratic risk and stock return in the long run. Stocks are sorted into portfolios for analysis and the whole sample period is further decomposed into decades for subgroup analysis. Multivariable regressions are used to study this relation as we control for beta, size, book-to-market ratio, momentum and liquidity. From a historical point of view, we show that the relation between idiosyncratic risk and stock return is time-varying, and it did not exist in certain decades. The results indicate that the risk-return tradeoff also varied in history.