Why Company-Specific Risk Changes over Time

Company-specific risk climbed steadily between 1962 and 1999 in the U.S. market but fell sharply between 2000 and 2003. This article explores the hypothesis that three factors are primarily responsible for observed changes in company-specific risk: changes in the market weights of “riskier” industries, changes in the relative role of small-capitalization stocks in the market, and measurement error associated with changes in within-industry concentration. Empirical tests reveal that each factor contributes to changes in company-specific risk over time and that, combined, these three factors largely explain changes in company-specific risk over the past 40 years.Recent studies have demonstrated that company-specific risk steadily increased between the early 1960s and the late 1990s. Since the market peak in 2000, however, company-specific risk has exhibited a secular decline. These changes are important to active managers because they have an impact on the effectiveness of portfolio diversification, tracking error, return dispersion across managers, and the ability of traders to exploit mispriced securities and because some recent research suggests company-specific risk may be rewarded (i.e., priced). A number of potential explanations have been offered that suggest fundamental changes in the economy and/or markets as the explanation for the rise in company-specific risk over time. Suggestions include decreases in operational diversification as companies narrowed their product/market focus, increased use of stock options as compensation, a rise in the volatility of returns on equity or growth opportunities, a decline in financial reporting quality, an increase in the role of institutional investors in the market and their tendency to herd, increases over time in levels of informed trading, an increase in capital market openness, and an increase in competition between companies.In the study reported here, we proposed and tested an alternative explanation for changes in aggregate company-specific risk: Carrying out tests for the August 1962–December 2003 U.S. market, we found that company-specific risk changes over time not as a result of fundamental changes in the market but, rather, as a result of changes in the composition of the securities that make up the market. Specifically, we proposed that three key changes in the composition of the market explain changes in company-specific risk over time: changes in the relative importance of industries, changes in the relative importance of small companies in the market, and changes in measurement error induced by changing within-industry concentration. Distinguishing between these explanations is important in practice because our explanation suggests that changes in company-specific risk faced by a given manager will be a function of the changes in that manager’s portfolio. For example, if a manager does not have great exposure to small-capitalization stocks, the rise in aggregate company-specific risk attributed to the growth of small-cap stocks in the market will not affect that manager.Empirical tests support each of our three hypotheses. Changes in within-industry concentration and the relative roles of small-cap stocks and riskier industries largely explain the patterns in company-specific risk over time. We conclude that these three factors are the primary culprits behind the long rise and recent decline of company-specific volatility over the past 40 years.