CFA Institute

Why Company-Specific Risk Changes over Time Author(s): James A. Bennett and Richard W. Sias Source: Financial Analysts Journal, Vol. 62, No. 5 (Sep. - Oct., 2006), pp. 89-100 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/4480775 Accessed: 15/04/2010 23:40
Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=cfa. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial Analysts Journal.

http://www.jstor.org

FinancialAnalysts Journal Volume 62. Number 5 ?2006, CFAInstitute

Why

Company-Specific Changes Risk

over

Time

James A. Bennett, CFA, and RichardW. Sias

risk Company-specific climbed 1962and1999in the U.S. market steadilybetween butfellsharply between2000 and 2003. This articleexploresthe hypothesis that threefactors are primarily responsiblefor observed in changes company-specific changes themarket risk: in weights "riskier" of in industries, changes therelative ofsmall-capitalization in themarket, measurement role stocks and errorassociated with changesin within-industry concentration. Empirical tests revealthateach factorcontributes changesin company-specific overtimeand that,combined, to risk thesethree factorslargely in explainchanges company-specific overthepast40 years. risk

number of recent studies [e.g., Campbell, Lettau, Malkiel, and Xu 2001 (henceforth, CLMX); Morck,Yeung,and Yu2000;Goyal and Santa-Clara 2003] have demonstrated that, although marketand industry risk remained relativelystablein theU.S.marketbetweenthe early 1960s and the late 1990s, company-specific risk climbedsteadilythroughoutthe period.Inaddition, as we demonstratein this study, company-specific riskhas exhibiteda seculardeclinesince the market peak in 2000. Changes in company-specificrisk over time affectportfolio managersfor a number of reasons. First, company-specificrisk is directly related to portfoliodiversification: Active managersattempting to achievesome given level of company-specific risk need to hold larger portfolios, all else being equal, during periods of high company-specific risk. This aspect is especially importantin light of recent research revealing that diversification requires portfolio sizes much greater than previously believed.Forexample,we have demonstrated (see Bennettand Sias 2006)that in recentyears, one in five investorsholding a randomlyselectedequalweighted 50-stock portfolio averaged an annual shock of 16 percent.Not surpriscompany-specific ingly, we reported that value-weighted portfolios (correspondingclosely to most portfolios held in practice)exhibitedeven greaterlevels of companyspecific risk. Second,the level of company-specific risk is directlyrelatedto both trackingerrorversus an index and the cross-sectional dispersionof active

James Bennett, A. CFA, assistantprofessor is offinance at theUniversity Southern of Maine,Portland. Richard W. Sias is a professor GaryP. BrinsonChairof and Investment Management Washington at StateUniversity, Pullman.
September/October 2006

portfolio returns (De Silva, Sapra, and Thorley 2001; Bennett and Sias 2006). When company-specific risk increases, managers have a greater likelihood of obtaining returns that differ (positively or negatively) from both indices and peers. Third, recent evidence (Goyal and Santa-Clara 2003; Jiang and Lee 2004) suggests that the aggregate level of company-specific risk is positively related to future market returns. Hence, the recent decline in company-specific risk portends lower future market returns if this pattern continues. Fourth, arbitrageurs' ability to exploit security mispricing is directly related to levels of company-specific risk; because the difficulty of forming arbitrage portfolios increases with an increase in company-specific risk, mispricings can persist longer during periods of high company-specific risk. Thus, for an informed active manager, the payoff from investing in an undervalued stock may take longer to realize when company-specific risk levels are high. Previous researchers have argued that changes in company-specific risk over time may reflect fundamental changes in the economy and/or markets, such as decreases in operational diversification as companies narrow their product/market focus (CLMX), an increase in the use of stock options as executive compensation (CLMX), systematic increases in the volatility of return on equity or growth opportunities (Wei and Zhang 2006; Cao, Simin, and Zhao 2005), a decline in financial reporting quality (Rajgopal and Venkatachalam 2005), an increase in the role of institutional investors in the market and their tendency to herd (Xu and Malkiel 2003), increases over time in levels of informed trading (Morck, Yeung, and Yu 2000; Durnev, Morck, and Yeung 2004), an increase in capital market openness (Li, Morck, Yang, and Yeung 2004), and an increase in competition between companies (Irvine and Pontiff 2005).
www.cfapubs.org 89

Financial Analysts Journal

In the study reportedhere, we tested a simpler explanationthan previously proposed for changes in aggregate company-specificrisk over time. To differsfrompreviunderstandhow our explanation considerthefollowing:The(valueous explanations, for risk, weighted)averagecompany-specific FIRMt, the Njtsecuritiesin the marketat time t is simply the risk productof each securityj's company-specific at time t, c2(j,t), and its time t weight in the market portfolio,wjt,summed acrosssecurities:
Njt

individual securities'betas. Following CLMX,we estimatedthe company-specificreturnfor stockj in industry i on day s as the daily deviation between the stock'sreturnand its industry'sreturn; used we the 49 industries defined by Fama and French (1997).We then computed the estimated monthly company-specificrisk for stock j in month t as the sum of the squared daily deviations over all days in month t:
(52(Ijiit) = set

is -Ris) S(2)

FIRM, =

w W11& (jt) -

(1)

j=1

Previous explanations for changes in FIRMt focusedon factorsinfluencingthe company-specific riskof individualsecurities,such as increaseduse of stock options, increased herding by institutional investors,or increasedcompetitionbetweencompanies. Our explanation focuses on changes in the weights of individual securities, which, in turn, determinethe relativeimportanceof industriesand small-capstocksin the marketand also affecterrors in estimatesof company-specific risk.1Specifically, we propose that threekey changes in the composition of the market explain changes in companyspecificrisk over time: * changesin the relativeimportanceof industries containing above-averagelevels of companyspecific risk,

where Rjsis securityj's returnon day s in month t and Ri, is the value-weighted industry return on day s.2 Aggregatecompany-specificrisk in month t is the weighted averagecompany-specificriskacross all securities:
Nj,

FIRM, =
j=l

Wjta

(it)

(3)

changes in the relative importance of small companiesin the market,and * changes in measurement error induced by changing within-industryconcentration. Distinguishing between these explanations is importantin practicebecauseour analysissuggests that changes in company-specificrisk faced by a given managerare a functionof the changesin that manager's portfolio. For example, as long as the manager does not have great exposure to smallstocks,the risein aggregatecompanycapitalization specific risk attributedto the growth of small-cap stocksin the marketwill not affectthat manager.In otherwords, accordingto our explanations, managers cancontroltheirexposureto time-varying aggregate company-specificrisk through industry and securityselection.Previousexplanationssuggested risk thatchangesin company-specific arepervasive, so a managercan do little to managesuch risks. *

Company-Specific Risk over Time

CLMXdemonstratedthat by aggregatingover all securities in the market,one can generate an estimate of company-specificrisk without estimating

Using Equations 2 and 3, we estimated company-specific risk for each month between August 1962 and December 2003 for all NYSE, Amex, and NASDAQ securities in the CRSPdatabase. Figure 1 graphs the estimated annualized (i.e., monthly variance estimate times 12) valueweighted company-specific volatility in the sample period. Figure1 reveals,as previously documentedby CLMX,an upward trend in company-specificrisk in the 1962-99period.At approximatelythe market peak in 2000,however, company-specificriskwent into a sharp decline. Following CLMX,we computed a linear trend coefficient(i.e., the coefficient from a time-series regression of aggregate company-specific risk on time) and a trend t-statistic that is robust to serial correlation (the Vogelsang t -PST t-statistic).3Estimates for the entire sample period (1962-2003),the period with generallyrisingcompany-specificrisk(1962-1999), and the period with generally falling companyspecific risk (2000-2003)are reportedin Table 1. The results in Table 1 reveal no evidence of a statistically significant trend in company-specific risk over the entire sample period, but companyspecific risk displays a statistically significant uptrendin the 1962-99period followed by a statistically significant downtrend during the 2000-03 period. In fact, company-specificrisk has declined so sharply since the marketpeak that it was lower in 2003thanthe averagecompany-specific over risk the 1970s.4

90

www.cfapubs.org

?2006,

CFA Institute

Why Company-Specific Risk Changes over Time

Figure 1.

Value-Weighted Company-Specific

Risk, 1962-2003

Value-Weighted Company-Specific Risk (%) 50 454035302520-

15 10

62

67

72

77

82

87

92

97

03

Note: Updated monthly.

Table 1.

Descriptive Statistics and Tests for Linear Trends in Company-Specific Risk

1962-2003 (n = 497 months) 7.954 5.362 0.802 1.624 1.443 1.689 1962-1999 (n = 451 months) 7.085 3.507 0.665 1.195 3.180** 3.381* 2000-2003 (n = 46 months) 16.084 10.556 0.803 -51.605 -3.328** -3.701*

Measure Mean risk (%) Standard deviation (%) Autocorrelation (lst order) Linear trend x 105 1 T-PS t-statistic (5%)
-PS'

t-statistic (10%)

Notes: Company-specific risk was computed monthly as the sum of the squared daily deviations between the stock's return and the value-weighted industry return weighted by the market value of the stock. These variance estimates were annualized by multiplying by 12. The critical values for the 10 percent and 5 percent levels for Vogelsang's t - PST- t-statistic are, respectively, 1.720 and 2.152. The linear trend for each risk measure was calculated from a regression of the monthly risk measure on time. *Significant at the 10 percent level. **Significant at the 5 percent level.

Why Does Company-Specific Risk Change over Time?

As demonstrated in Figure 1 and Table 1, companyspecific risk exhibited a secular uptrend between 1962 and 1999. As a result, most explanations for changes in company-specific risk focus on explaining the rise in company-specific risk over time (e.g., increased herding by institutional investors). The results in Figure 1 and Table 1 suggest, however, that any explanation for changes in companyspecific risk over time should explain both the September/October 2006

increase over the 1962-99 period and the subsequent decline. In addition, most previous explanations implicitly assumed that changes in value-weighted average company-specific risk are driven by changes in the return-generating process itself (i.e., that the distribution of company-specific shocks for each security changes over time) rather than changes in weighting. Equation 1, however, shows that given different levels of company-specific risk among securities, changes in weighting will cause aggregate company-specific risk to change over time. Therefore, we next present evidence that the
www.cfapubs.org 91

Financial Analysts Journal

three factorsassociatedwith changes in weighting largely explain the changes in company-specific risk over time. Changes in Industry Weights. In August 1962(thefirstmonthin our sampleperiod),the four largestindustries-petroleum and naturalgas, utilities, telecommunications, and automobilesaccountedfor 44 percentof aggregatemarketcapitalization. By December 2003, those industries accountedfor only 14 percentof marketcapitalizathe tion. Similarly, four largestindustriesat the end of the sample period-banking, business services, pharmaceuticals,and trading-accounted for 36 percent of the market capitalizationin December 2003 but only 5 percent of the aggregate market capitalizationin 1962. As long as industries have different levels of company-specificrisk, changes in industry weights will lead to changes in the weighted averagecompany-specificriskover time. shocksarisingfrom Forexample,company-specific a change in technologywill affecta greaterfraction of the market in today's environmentthan previously becausethe relativevalue of technologycompanies has increasedover time. To examine the possibility that changes in industryweights help explainchangesin companyspecific risk, we assigned each of the 49 industries to one of two groups-"Risky" or "Safe."SpecifiFigure 2.

cally, we computed the value-weighted average company-specific risk of securities within each industryover the August 1962-July1964periodand then defined those industries with median and above-mediancompany-specificrisk as Risky and risk as those with below-mediancompany-specific eachmonth,the ratioof the Safe.Wethencalculated, total capitalizationof Risky industries to the total of capitalization Safeindustries.Figure2 graphsthis ratio, as well as aggregate company-specificrisk, over time.Thepatternis clear:Aggregatecompanyspecificriskrises (falls)as riskierindustriesbecome a larger(smaller)partof the market. As a formal test that changes in industry weights help explain changes in aggregate company-specificrisk, we computed the correlation between realized aggregatecompany-specific risk and a hypothetical forecast of company-specific risk calculated by assuming that companyspecificriskwithin each industryremainsconstant over time but industryweights vary over time. We beganby computingthe value-weightedcompanyspecificriskin eachindustryover the firsttwo years in the sample period as the (constant)estimate of the company-specificrisk for each industry in the future.For each month subsequentto the first two of years in the sample,we computed the "forecast" company-specificrisk as the sum (across indus-

Ratio of Market Value of Risky Industries to Market Value of Safe Industries Compared with Company-Specific Risk over Time, 1962-2003
of TotalCapitalization RiskyIndustriesto of TotalCapitalization Safe Industries 1.0 . Company-Specific Risk2 ~~~~~~(left axis) 0.9

Risk(%) Company-Specific Value-Weighted 50 45

40 0 40
35 30 25
F

08 0.
0.7 0.6

RiskyIndustries/SafeIndustries
axis) 0

20:(right

15

0.3

62

67

72

77

82

87

92

97

03

Note:Updatedmonthly. ?2006, CFA Institute

92

www.cfapubs.org

Why Company-Specific Risk Changes over Time

tries) of the products of each industry's actual weight at time t and the constantestimate of company-specific risk for that industry. That is, although we updated the industry weights each risk month,the estimateof company-specific in each industrywas held constantat its averagevalue over the first two years in the sample period. The timeseries correlationbetween actual aggregate company-specificriskand this monthlyforecastof company-specific risk based solely on changing industryweights was found to be 51.47percentand statisticallysignificantat the 1 percentlevel. Company Size. The numberof small companies in the sample grew dramaticallyover time as the sample size increased from 2,039 securities in August 1962to a peak of 9,146securitiesin December 1997. The number of small companies subsequently declined as the number of companies fell from the 1997peak to 6,690securitiesin December 2003.Although aggregatecompany-specificrisk is a value-weighted measure, the dramaticrise and subsequent fall in the number of securities in the sample suggests thatchangesin the relativeimportance of small-cap stocks in the market may help explain observed changes in aggregate companyspecific risk over time. We began to examinethis relationship partiby tioningstocksinto two groupseachmonth:"Large" (the largest-capstocks that, in total, accountedfor

half of the total marketcapitalization time t) and at "Small" (the remaining stocks, which also accountedfor half of marketcapitalization). Figure 3 graphsthe ratioof numberof Smallto numberof Largeand repeatsthe graphof aggregatecompanyspecific risk over time. Figure 3 reveals a strong positive relationshipbetween this ratio and valueweightedcompany-specific At thebeginningof risk. the sample period, there were approximately37 small-capstocksfor every large-capstock.Theratio closely tracked the pattern in aggregate valueweighted company-specificrisk. The ratio rose to more than 100 small-capstocks for every large-cap stockby the end of 1999.Byyear-end2003,however, the ratiohad fallen to 57 small-capstocks for every large-capstock. Similarto our analysis of changes in industry weights, we generateda formaltest of the hypothesis that the rise and subsequentfall in the relative role of small-capstocksin the markethelps explain changes in aggregate company-specific risk by between realized aggrecomputing the correlation gate company-specificriskand a hypotheticalforecastof company-specific designed to isolatethe risk impactof changesin the weight of small-capstocks over time.We rankedthe 2,039securitiesin the first month of the sample period (August 1962)by size and placed them in size deciles. Each of the first nine decilescontained204stocks;the remaining203 stocks were placed in the bottom decile (smallest

Figure 3. Ratio of Numberof Small Companies to Numberof Large Companies Compared with Company-Specific Risk over Time, 1962-2003
Value-Weighted Company-Specific Risk(%) 50 4540Numberof SmallCompanies/ Numberof LargeCompanies axis) ~~~~(right 100 Ratioof Smallto Large 120

80

30 25 20 15

60

10~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~1
-

Risk(left ~~~~~~~Company-Specificaxis)
A,I

0
62

0
03

67

72

77

82

87

92

97

Note:Updatedmonthly. 93

September/October 2006

www.cfapubs.org

Financial Analysts Journal

companies).Then,holding the numberof securities in each of the top nine deciles constantat 204in each subsequentmonth,we placed all remainingsecurities into the bottom decile. Thatis, each month, the firstnine deciles containedthe largest 1,836securities (9 x 204) and the final decile contained all remaining securities. We then estimated each decile's weighted average company-specific risk over the first two years in the sample period as our constantestimate of company-specificrisk for that size decile in the future.In each subsequentmonth (excluding the first two years), we computed the risk forecastof company-specific as the sum (across size deciles) of the products of each decile's time t market weight and the constant estimate of risk company-specific for thatdecile.Thus,as in our industry analysis,although the size-decile weights were updated each month, the estimate of company-specificrisk within each decile was held constantat its averageover the firsttwo yearsin the sample period. As a result, changes in the level of the forecastedweighted averagecompany-specific risk over time were completely a result of changes in the relativeweights of the size deciles. The timeseries correlationbetween this monthly forecastof company-specific risk and actual aggregate risk company-specific was found to be 24.88percent and statisticallysignificantat the 1 percentlevel. In summary,despite the factthatthe companyspecificriskmetricis value weighted, we found that the growth and subsequent decline of small-cap securities in the market play a substantialrole in accountingfor the changes in aggregatecompanyspecificrisk over time. Changes in Within-industryConcentration. Theanalysisthusfarhas demonstrated changes that in market weights affect aggregate companyspecific risk by changing both the relative importance of industries with high versus low levels of company-specificrisk and the relativeimportance of small-capversus large-capstocks.Theimpacton risk caused by weighted averagecompany-specific these changes in weights may be considered a "direct" effect. Changes in securityweights also have a more subtle, "indirect"effect on estimated companyspecificrisk,however, because of the estimationof returnsas the differencebetween company-specific securityand industryreturns.All else being equal, returns the including themselves, estimatedcompanyspecific risk for a particularsecurity (and thus the aggregatecompany-specificrisk for a given industry and the overallmarket)will vary with the distribution of marketcapitalizationamong companies within an industry. Specifically,assuming returns
94 www.cfapubs.org

are generated by a linear factor model in which securitieswithin each industryhave homogeneous factor sensitivities (i.e., homogeneous betas), the estimated value-weighted average companyspecific risk of companies in the industry is given by (proofavailablefrom authorsupon request):
a2 a2( (i~=a2(i.~w2.ajii 2t (f(i,t)

(jit) j)

(4)

jcri

where c2(fiit) is the true (unobservable) weighted average company-specificrisk in industry i and ca2(iit)is the estimatedweighted averagecompanyspecificrisk in industryi.5 Thefirsttermon theright-hand of Equation side 4 is the "true"weighted averagecompany-specific risk in the industry. The second term, however, demonstratesthat estimated company-specificrisk will depend on the distributionof within-industry weights; therefore, the second term represents a potentialsourceof bias.6 Two intuitive examples will demonstrate that this bias is likely to cause estimated company-specific risk to increase (decrease) when within-industry concentration declines (increases). First, consider the extreme case of industry concentration-an industry consisting of a single company.7 In this situation, industry returnswill equal the company's returnsand estimated company-specific returns (and risk) will equal zero, even if the company truly does experience company-specific shocks.8 Or consider a less extreme example, one in which the truevarianceof company-specific shocks is some constant,C, across all securitieswithin an industry;that is, a2
(jit)=

(5)

for all securitiesin industry i. In such a case, Equation 4 simplifies to the industry's true average company-specificrisk, C, times 1 less the industry portfolio's Herfindahlindex; that is,9
2
(JC(j i2

(6)

In otherwords, when securitiesin an industryhave the same level of company-specific risk,an increase in industryconcentration leads to an increasein the downwardbias in estimatedcompany-specific risk. In addition,the magnitudeof the bias will be minimized when marketcapitalizations equal across are companiesin the industry.Although not all securities in an industryare likely to possess equal levels of company-specific risk, Equation4 demonstrates thatthenegativebiasin estimatedcompany-specific risk for any industry is maximized when industry
?2006, CFA Institute

WhyCompany-Specific Changesover Time Risk

concentrationis maximized:As the weight of any company within an industry approaches 1, estimated company-specific risk for the industry approaches0. In general,however, the set of weights wjitthat minimizes the bias term (i.e., the second term in Equation4) will depend on the specific values of
the true company-specific risk,
2(ijit),

across

companies. The question of how concentration affectschanges in estimatedcompany-specificrisk over time is ultimately an empirical one, and it cannot be ignored unless concentrationis either very low or constantover time. Empirically,U.S. marketconcentrationis both high and variable over time; less than half of 1 percentof securities,for example, made up the top quarterof the market'scapitalization,on average, between 1962and 2003. Over time, however, markets have become somewhat less highly concentrated. Figure 4 graphs the weighted average within-industry Herfindahl index and aggregate company-specific risk over time.10 The graph reveals a steady downtrend in within-industry concentrationbetween 1962and 1999followed by a slight increasein concentrationsince then, which is consistent with the hypothesis that estimation errorinduced by changes in within-industry con-

centration contributes to changes in estimated company-specificrisk over time.11In the absence of such a bias, this negative relationshipbetween industry concentration and estimated companyspecific risk may be counterintuitive.One might expect that as industry profitability declines, the industry will consolidate (i.e., concentrationwill increase) and company-specificrisk will increase because of greateruncertainty(i.e., a positive relationship exists between concentration and company-specificrisk).12 In our study, we next performed a simple examination of the potential role that changing industry concentration plays in explaining changes in company-specificrisk over time. Using only returns from the first month in the sample period and holding the role of small companies and industry weights constant, we examined whether realized changes in industry concentration, by themselves, help explain changes in company-specific risk over time. We began by computing industry weights and companyspecific riskmeasuresbased on the sample of 2,039 securities in 48 industries in August 1962.13We then identified the number of companies in each industry and ranked each security in its industry

Figure 4. Industry Concentration Compared with Company-Specific Risk over Time, 1962-2003
Value-Weighted Company-Specific Risk(%) 50 45 40 35 30 25 20 15
10

IndustryConcentration (Herfindahl Index) 0.25

WeightedAverageWithin-Industry Concentration Index (rightaxis)

0.20

01

a~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ i
01 :
0.05

.^--:--.* .-: 0 62 67 72

*--- Company-Specific Risk (left axis) A

. 0

77

82

87

92

97

03

Note: Updatedmonthly.

September/October 2006

www.cfapubs.org

95

Financial Analysts Journal

based on its capitalization at the beginning of August 1962.Thus, in August 1962,the companyspecific portion of company j's return was estimated as
Nth lj,iJ,se8/62
-

Nth Rji,se8/6

R
E

Nth = Rj,ise8162 -

NI ,j=l

Nth Nth Wjit 11Rj,i,se8162'

(7)

In summary,the definitionof company-specific returns as the difference between a company's return and an index that includes the company's return induced a dependency between estimated company-specific risk and the distribution of weights acrosscompanies.As a result,measurement errorassociatedwith changingindustryconcentration contributedto changes in estimatedaggregate company-specific over time. risk

where Ni securities were in industry i in August 1962and RN.th is the returnon the Nth largestj, i, S E8/62 cap securityin industry i on day s in August 1962. For August 1962, with is securityj's weight in its industry for that month and securityj is the Nth largest-capsecurityin its industry. We repeated this procedure each month and used updated securityweights only in the calculation of the industry return (i.e., within-industry weights fromtime t were used to computeRiS E8/62). For all other calculations,weights were held constant at August 1962 values. Thus, in September i962,wNth in Equation7 was computed as the capitalizationof the Nth largest-capsecurityin industry i divided by the total capitalizationof the Ni largest-cap securities in industry i in September 1962.As we moved forwardthroughtime,the number of securities in most industries grew as small companies were added. By limiting the sample to the Ni largest-capsecurities in each industry each month, we eliminated the changes in companyspecific risk resultingfrom changes in the number of small companiesin the sample.14 We then computed the estimate of companyspecific risk for a given company in the same fashion as before,by summing the squareddifferences between the August 1962 daily returns and the time-varying industry return computed with August 1962returnsbut time t industryconcentration (i.e., company weights at time t were used to compute industry concentration).The weighted average company-specific risk across companies within an industry was then calculated by using August 1962 marketvalues to control for changes in company-specificrisk arisingfrom directeffects of changing weights, and the weighted average of company-specific risk for the market was computed by using August 1962 industry weights to controlfor changesin company-specificriskresulting from the growth of riskierindustries.The timeseries correlation between aggregate companyspecific risk and the forecast of company-specific risk that was fully driven by changing industry concentrationwas found to exceed 55 percent (statistically significantat the 1 percentlevel).
96 www.cfapubs.org

Controlling for the Three Factors

The analysis thus far reveals that three factors (changes in the relative role of riskier industries, changesin the relativeroleof smallcompaniesin the sample, and changes in within-industryconcentration)contributeto changesin company-specific risk over time. In this section,we examine the relationship between company-specific and time while risk controllingfor all threefactorssimultaneously. We took two approaches to these tests. First, we reestimated company-specific risk over time while attempting to directly control for the three factors.Second,we includedvariablesproxyingfor each of the factors in the regression of companyspecific risk on time.

Controlling the Sample. We examined changes in company-specificrisk over time while controllingfor the threefactorsby holding industry weights,within-industry and concentration, sample sizes constantat August 1962 levels. We began by limiting our sample in all months to stocks with a price of at least $1.00.15 This step reducedthe number of securitiesin August 1962from2,039to 1,989. We then computed company-specificrisk for August 1962 as previously described, based on Equations2 and 3. Forsubsequentmonths,we limited the sample to the Ni largest companies in industry i (to controlfor changes in the numberof small-cap stocks in the market) and computed company-specificreturns for the Nth largest-cap securityin industryi at time t as
^Nth= RNth Nth Nth

where Ni is the numberof securitiesin industryi in Nth August 1962 and RJNthis the return for the Nth largest-capsecurity(securityj) in industryi on day s. To controlfor changes in industryconcentration, we used 1962 within-industry weights (i.e., Nth= 8/62 is the August 1962industryweight of the Nth largest-capsecurityin industryi).16 We then estimated company-specificrisk for each subsequentmonth on the basis of August 1962 within-industryweights (which also controlledfor
02006, CFA Institute

Why Company-Specific Risk Changes over Time

and changing industry concentration) August 1962 industry weights (to controlfor changing industry weights over time):
48
Wi,t=8/62
[N.

F Nth 21
WJ,t=8/62 j

(FIRM); is, we comparedthe trend coefficients that for the estimates in Figure 1 with the trend coefficients for the estimates in Figure 5. We then estimatedthe fractionof the unrestricted trendthatwas accountedfor by the three factorsas
%Trend resulting size,industry, concentration from and

(9) =1FIRM* Trend Trend FIRM (10)

Thus, FIRM*, graphed over time in Figure 5, denotes estimated company-specificrisk aftercontrol for changes in the role of small-cap stocks, riskier industries, and the bias induced by changing industry concentration. The results in Figure5 reveal little evidence of a systematic rise in company-specificrisk afterwe controlled for the three factors over the 1962-99 period. In addition, the rise in idiosyncratic risk during the technology/media/telecommunications (TMT)bubble is much more muted than in Figure 1. Nonetheless, even when the three factors were controlled for, company-specificrisk can be seen to have increased during the bubble period and then to have declined. To quantify the differencebetween Figures 1 and 5, we estimated trend coefficientsfor the measure of company-specificrisk after controllingfor all three factors(FIRM*) both the period of genfor erallyrising company-specificrisk (1962-1999)and the period of generally falling company-specific risk (2000-2003)and compared these trend coefficientswith those estimatedfor the same periods for the unrestrictedestimate of company-specificrisk
Figure 5.

We found that the three factorsaccounted for 63 percentof the trendcoefficientduring the period of rising company-specificrisk (1962-1999)and 56 percentof the trendcoefficientduring the period of falling company-specific risk (2000-2003). Thus, even given the tremendousrisein company-specific riskaroundthe TMT bubble,the resultssuggest that changes in the relative roles of small-cap stocks, riskierindustries,and estimationerrorinduced by changing industry concentrationaccounted for a majorityof the trend in both the periods.
Regression Tests: Controlling for Size, Industry, and Concentration Effects. We next

estimated the effect of these factorsby controlling

for them in the regressions of value-weighted

company-specific risk on proxies for each factor and time. We used the ratio of the capitalizationof
Risky industries to Safe industries as a measure of

changesin the role of riskierindustries (as graphed in Figure2). Wemeasuredthe role of small companies in the samole at time t as the ratio of the

Company-Specific Risk after Controlling for Size, Industry Weights, and Concentration, 1962-2003

Risk (%) Company-Specific 50 4540 353025201510 5

0 62 67 72 77 82 87 92 97 03

Note:Updated monthly.

September/October

2006

www.cfapubs.org

97

Financial Analysts Journal

number of companies accounting for the bottom half of the market'stotal time t capitalizationto the number of companies accounting for the top half (as graphedin Figure3). Weaccountedfor changes by in within-industryconcentration calculating,for each month, the weighted average (across industries) of each industry's Herfindahl index (as graphed in Figure4). We estimated regressions of value-weighted from Equation3) on company-specificrisk (FIRMt time, the ratio of Small to Large, the valueweighted within-industry Herfindahl index, and the ratio of the total capitalizationof securities in Risky industries to the total capitalizationof securities in Safe industries. Because of the serially correlatednatureof volatility (see Table1),we also repeated the analysis with lagged companyspecific risk included as an additional variable. Regression coefficients and associated t-statistics (based on Newey-West 1987standarderrorswith six lags) are reported in Table 2. Table 2. Regression of Value-Weighted Company-Specific Risk on Sample Characteristics and Time, 1962-2003 (t-statisticsin parentheses)
Variable Intercept(xlO) risk Laggedcompany-specific Time (x103) Small/Large(x102) Industryconcentration Risky/Safe N (months) AdjustedR2 -0.287 (-3.81)*** 0.194 (5.90)*** -0.620 (-3.48)*** 0.230 (3.58)*** 496 58.4% Regression1 0.520 (1.50) Regression2 0.285 (1.52) 0.522 (5.52)*** -0.143 (-3.24)*** 0.091 (4.08)*** -0.315 (-2.92)*** 0.114 (2.88)*** 496 69.8%

company-specificrisk. In addition, the coefficient on time is negative, suggesting that once these factorshave been accounted for, the overall trend in company-specificrisk is down. Moreover, the negative coefficienton time was not driven by the risk declinein company-specific following the TMT bubble;limiting the sample to the 1962-99 period yielded qualitativelyidenticalresults. Other Explanations for Changes in Company-Specific Risk over Time. As noted in the introduction,previous researchersproposed a numberof explanationsforthe systematicrisein the volatility of individual securitiesover the 1962-99 period, including a reductionin conglomerates,an increasein executivestockoptions,a systematicrise in the volatilityof returnon equityor growthopportunities, an increase in herding by institutional investors,an increasein the level of informedtrading, greatercapital market openness, a decline in financialreportingquality,and an increasein competitionbetween companies. Our results are not necessarily inconsistent with many of the previous explanations.Forexample, changesin the relativeimportanceof small-cap stocks and riskier industries over time will cause changesin the averagevolatilityof returnon equity and financialreportingquality over time. In addition, nearly all the other explanations for changes in company-specific risk have attemptedto explainonly the uptrendin companyspecific risk in the 1962-99 period, not the decline in company-specific since 2000.In contrast,our risk results suggest that the role of small companies, riskierindustries,and changes in industryconcentration contributedto the dramaticrise and fall of aggregate company-specificrisk around the TMT bubble. However, although the rise and fall of company-specificrisk around the TMTbubble in Figure5, which reflectscontrolfor the threefactors we suggest, is much more muted than in Figure 1, Figure5 still documentsa rise in company-specific risk around the TMTbubble. Therefore,Figure 5 suggests that other factorsplayed a role in the rise and fall of company-specificrisk at the time of the TMTbubble.Brandt,Brav,and Graham(2005)provided an additional likely explanation-namely', that excessive speculationat that time contributed to the rise in aggregatecompany-specificriskin the late 1990sand its subsequentdecline since 2000. have noted that the numPreviousresearchers ber of small companies (which typically have higher levels of company-specificrisk than large companies)increasedover the 1962-99period.Previous work, however, largely discounted the possibility that these securities played an important measure of role in changes in the value-wleighted company-specificrisk.
X)2006, CFA Institute

Notes: secondregressionincludedlagged company-specific The risk as a controlvariable.The t-statisticsare based on NeweyWest standarderrorswith six lags. Significantat the 1 percentlevel.

Table 2 reveals statisticallysignificant coeffiand industry risk cients on the size, concentration, and these variables have the expected variables, signs: Value-weighted company-specific risk increases as the role of small companies in the sample increases,as the relativeimportanceof riskier industriesgrows, and as industriesbecome less concentrated. The results held regardless of whether we accountedfor the serial correlationin
98 www.cfapubs.org

WhyCompany-Specific Changesover Time Risk

No otherstudy has consideredthe influenceof changing industry weights or changes in estimation error induced by changing industry concentration on estimates of value-weighted company-specific risk. In this work, we demonstratedthatboth of these factorsplay an important role in explaining the observed changes in company-specificrisk over time.

Conclusion
Aggregate company-specific risk exhibited a steady upward trend over the 1962-99 period and a steep decline in the 2000-03 period. Because risk changesin company-specific affectthe number of securities needed to achieve a given level of diversification, tracking error, cross-sectional returndispersion across managers,and the ability of arbitrageursto exploit mispricing and because company-specific risk may be priced, an understanding of how and why company-specificrisk changes over time is important. Previous work suggested that changes in company-specificrisk are driven by fundamental changes in markets or the retum-generatingprocess. We posited that changes in company-specific

risk reflectchanges in the compositionof securities used to estimate company-specific risk. Distinguishing between these explanationsis important in practicebecause our explanation suggests that managers can control their exposure to timevarying company-specific risk through industry and security selection. If changes in companyspecificriskarepervasive (drivenby changesin the company-specific risk of individual securities), however,a managercando littleto controlthe risks. Our empirical tests support our hypotheses: Changes in the relative importance of riskier industries, changes in the relative importance of small companies in the market, and changes in estimated company-specific risk associated with estimation error related to changes in industry concentrationlargely drive changes in companyspecific risk over time. We thankTim Vogelsang kindlyproviding for Gauss code.Wethankseminar at participants the University ofMontana, University NewHampshire, the the of and 2004 Financial Management Association meetings for helpful comments.
This articlequalifies 1 PDcredit. for

Notes
1. Althoughwe focuson changesin weights,we do not assume to risk company-specific forindividualsecurities be constant over time. In a recentworking paper, Fink,Fink,Grullon, and Weston(2005)arguedthatthe increasein the numberof young companiesgoing public largelyexplainsthe steady risk rise in company-specific over time (i.e.,thatchangesin weights arisingfrom an increasein the numberof young thanchangesin riskitself,areresponsible companies,rather risk for the increasein company-specific over time). capitalizations, 2. FollowingCLMX, usingbeginning-of-month we computed monthly industry returns as the valuewithintheindustry. for return allsecurities weightedaverage 3. The calculationof the Vogelsangt-statisticdepends on the desiredsignificancelevel. See Vogelsang(1998)for details. 4. The long uptrend(1962-1999)and subsequentdowntrend reportedin Table1 were not drivenby outliers. (2000-2003) in Specifically, unreportedtests,we excludedOctober1987 fromthe analysisand limitedthe uptrendperiodto August 1962 through December1998 (i.e., excluding the spike in company-specificrisk in calendar year 1999). The linear trend coefficient fell only 18 percent (from the 1.195 reported in Table 1 to 0.976) and remained statistically significant at the 5 percent level. Similarly, when we excludedthe firstsix monthsof calendaryear2000fromthe downtrendperiod,the coefficientmagnitudefell 13percent significantat (from-51.605to -44.876)and was statistically the 10 percentlevel. risk in 5. The weighted averageestimatedcompany-specific is the market(FIRMt) simply the sum of Equation4 across the 49 industriesweighted by industrycapitalization. September/October 2006 6. All variablesin the second termof Equation4 arepositive, so this term will induce a downward bias in estimated company-specificrisk. This bias does not influence total risk,only how risk is partitionedamong market,industry, and company-specific risk. 7. Moregenerally,consideran industrywith manycompanies but only one of them is contained in the CRSPdatabase while the rest are eitherprivateor foreignlisted. 8. The idea that industry concentration affects estimates of risk company-specific is informally recognizedin a number of studies. Forexample,authorsof studies of international data (whichusuallyincludemarkets with even greaterconthan found in the U.S. markets)commonlyesticentration matecompany-specific forsecurityjas security return risk j's less the averagereturnon all stocksotherthanj (e.g.,Liet al. 2004).Note, however,thatas shown in Equation such an 4, will adjustment not generallyresultin an unbiasedestimate. 9. TheHerfindahl index,a measureof industryconcentration, is calculatedas the sum of the squared within-industry it weights;therefore, has a maximumvalue of 1. Forexample, if an industrycontainsonly two securitiesof equalsize, the Herfindahlindex is 0.52+ 0.52. 10. Theweighted averagewithin-industry Herfindahlindex is the Herfindahlindex in each industry weighted by the industry'smarketweight at the beginningof the month. 11. Decliningconcentration reduces the negative bias in estimated company-specificrisk (under the assumptionthat withinanindustryhave similarcompany-specific securities in risk) and is thus associated with an expected increase risk. estimatedcompany-specific 12. We thankan anonymousrefereefor pointingthis out. www.cfapubs.org 99

Financial Analysts Journal 13. No companieswere classifiedas in the "healthcare"industry in August 1962. 14. Fora few industries,samplesizes at somepointin timewere smaller(i.e., there were fewer securitiesin the industryat time t thanthe Ni securitiesin the industryin August 1962). In those cases, we simply computed the company-specific portionof the returnbased on the remainingsecurities.For example, if there were 100 securities in the industry in 1962,within-industry August 1962and only 99 in September were based on the sample of 99 securities(and still weights summedto 1). 15. As discussed later, we used security weights based on August 1962 levels but returnsfrom time t. Without this a constraint, stock with a very low price at time t could be assigned a relativelylarge weight in a shrinkingindustry. Forexample,in 2002,a single low-pricesecurity(Tramford International) a 1,600percentone-dayreturnas its price had went from2 cents on 8 August to 33.91cents on 9 August. 16. If an industryhad moresecuritiesin a futuremonththanin August 1962,we implicitlyassigned the additionalsecurities a weight of zero. If the industryhad fewer securitiesin a future month, we scaled the assigned weights from August 1962to sum to 1;we used theseweights to calculate the month t industry return.Once company-specificrisk was calculatedfor each security,we returnedweights to their unscaled August 1962 values and gave the smallest securitythe "missing"weight. This approachwas equivalent to assumingthe missingsecuritieshad the sameriskas the smallestsecurityin a shrinkingindustry.

References
Is J., Bennett, andR.Sias.2006."HowDiversifiable Firm-Specific Risk?" Working paper, University of Southern Maine and WashingtonStateUniversity. Brandt,M., A. Brav, and J. Graham.2005. "TheIdiosyncratic Volatility Puzzle: Time Trend or Speculative Episodes?" Workingpaper,Duke University. Campbell,J., M. Lettau, B. Malkiel, and Y. Xu. 2001. "Have Individual Stocks Become More Volatile? An Empirical vol. 56, of Explorationof IdiosyncraticRisk."Journal Finance, no. 1 (February):1-43. Cao, C., T. Simin, and J. Zhao. 2005. "Can Growth Options Explain the Trend in Idiosyncratic Risk?" Working paper, PennsylvaniaStateUniversity. Dispersion de Silva,H., S. Sapra,and S. Thorley.2001."Return vol. 57, AnalystsJournal, and Active Management."Financial no. 5 (September/October):29-41. Durnev, A., R. Morck,and B. Yeung. 2004. "Value-Enhancing Stock ReturnVariation." CapitalBudgetingand Firm-Specific vol. of Journal Finance, 59, no. 1 (February):65-105. Fama, E., and K. French. 1997. "IndustryCosts of Equity." vol. Economics, 43, no. 2 (February):153-194. of Journal Financial G. Grullon,and J. Weston.2005."IPOVintage Fink,J.,K. Fink, and the Rise in IdiosyncraticRisk." Working paper, James MadisonUniversityand RiceUniversity. Goyal, A., and P. Santa-Clara. 2003. "Idiosyncratic Risk vol. Matters!" of Journal Finance, 58, no. 3 (June):975-1007. ReturnVolatility, Irvine,P., and J. Pontiff.2005. "Idiosyncratic Working paper, Competition." CashFlows,andProductMarket Universityof Georgiaand BostonCollege. Jiang,X., and B. Lee. 2004. "Onthe DynamicRelationbetween Returns and Idiosyncratic Volatility." Working paper, Universityof NorthernIowa and Universityof Houston. Li, K., R. Morck,F. Yang, and B. Yeung. 2004. "Firm-Specific Variation and Openness in Emerging Markets." Review of vol. Economics Statistics, 86, no. 3 (August):658-669. and Content B.Yeung,andW.Yu.2000."TheInformation Morck, R., of Stock Markets: Why Do Emerging Markets Have Synchronous Stock Price Movements?"Journalof Financial Economics, 58, no. 1 (October):215-260. vol. Newey, W.K.,and K.D.West. 1987."A Simple,Positive SemiDefinite, Heteroskedasticityand AutocorrelationConsistent vol. Matrix." Covariance Econometrica, 55, no. 3 (May):703-708. Rajgopal, S., and M. Venkatachalam. 2005. "Financial ReturnVolatilityover the ReportingQualityand Idiosyncratic LastFourDecades."Workingpaper,Universityof Washington and Duke University. FunctionHypothesisTestingin the Vogelsang,T. 1998."Trend vol. Presence of Serial Correlation."Econometrica, 66, no. 1
(January):123-148.

Wei, S., and C. Zhang. 2006. "Why Did Individual Stocks Become More Volatile?"Journalof Business,vol. 79, no. 1
January):259-292.

Xu, Y., and B. Malkiel. 2003. "Investigatingthe Behaviorof Idiosyncratic Volatility." Journalof Business,vol. 76, no. 4 (October):613-644.

100

www.cfapubs.org

02006,

CFA Institute