Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk

This paper uses a disaggregated approach to study the volatility of common stocks at the market, industry, and firm levels. Over the period from 1962 to 1997 there has been a noticeable increase in firm-level volatility relative to market volatility. Accordingly, correlations among individual stocks and the explanatory power of the market model for a typical stock have declined, whereas the number of stocks needed to achieve a given level of diversification has increased. All the volatility measures move together countercyclically and help to predict GDP growth. Market volatility tends to lead the other volatility series. Factors that may be responsible for these findings are suggested. IT IS BY NOW A COMMONPLACE OBSERVATION that the volatility of the aggregate stock market is not constant, but changes over time. Economists have built increasingly sophisticated statistical models to capture this time variation in volatility. Simple filters such as the rolling standard deviation used by Officer ~1973! have given way to parametric ARCH or stochastic-volatility models. Partial surveys of the enormous literature on these models are given by Bollerslev, Chou, and Kroner ~1992!, Hentschel ~1995!, Ghysels, Harvey, and Renault ~1996!, and Campbell, Lo, and MacKinlay ~1997, Chapter 12!. Aggregate volatility is, of course, important in almost any theory of risk and return, and it is the volatility experienced by holders of aggregate index funds. But the aggregate market return is only one component of the return to an individual stock. Industry-level and idiosyncratic firm-level shocks are also important components of individual stock returns. There are several reasons to be interested in the volatilities of these components. * John Y. Campbell is at Harvard University, Department of Economics and NBER; Lettau is at the Federal Reserve Bank of New York and CEPR; Malkiel is at Princeton University; and Xu is at the University of Texas at Dallas. This paper merges two independent projects, Campbell and Lettau ~1999! and Malkiel and Xu ~1999!. Campbell and Lettau are grateful to Sangjoon Kim for his contributions to the first version of their paper, Campbell, Kim, and Lettau ~1994!. We thank two anonymous referees and René Stulz for useful comments and Benjamin Zhang for pointing out an error in a previous draft. Jung-Wook Kim and Matt Van Vlack provided able research assistance. The views are those of the authors and do not necessarily ref lect those of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors and omissions are the responsibility of the authors. THE JOURNAL OF FINANCE • VOL. LVI, NO. 1 • FEBRUARY 2001