Considerable attention has been given in the financial press to the increase in stock market volatility during the late 1990s. The facts suggest, however, that this attention has been misplaced. As shown first by Schwert (1989), no long-run uptrend is evident for the volatility of the market as a whole. The volatility of the market during the late 1990s, while larger than it was earlier in the decade, was still considerably below the volatility recorded during earlier periods of the century.
What has received far less attention is the behavior of the volatility of individual stocks. The volatility of individual stocks can increase even when the volatility of the market as a whole remains stable as long as correlations among stocks are declining. In this study, we show, from a different perspective and using different measures from those used by Campbell, Lettau, Malkiel, and Xu (2001), that volatilities of individual stocks have indeed increased over the decades of the 1980s and 1990s. When the total volatility of individual stocks is decomposed into systematic volatility and idiosyncratic volatility, we present clear evidence that idiosyncratic volatility has trended up. We find that our result is not solely attributable to the increasing prominence of the NASDAQ market. Most importantly, we find from cross-sectional regressions that the volatility of individual stocks may be related to the amount of institutional ownership and to the firms’ objectives in pursuing high growth.
What has received far less attention is the behavior of the volatility of individual stocks. The volatility of individual stocks can increase even when the volatility of the market as a whole remains stable as long as correlations among stocks are declining. In this study, we show, from a different perspective and using different measures from those used by Campbell, Lettau,Malkiel, and Xu (2001), that volatilities of individual stocks have indeed increased over the decades of the 1980s and 1990s. When the total volatility of individual stocks is decomposed into systematic volatility and idiosyncratic volatility, we present clear evidence that idiosyncratic volatility has trended up. We find that our result is not solely attributable to the increasing prominence of the NASDAQ market. Most importantly, we find from cross-sectional regressions that the volatility of individual stocks may be related to the amount of institutional ownership and to the firms’ objectives in pursuing high growth.
While idiosyncratic volatility can be eliminated in a well- diversified portfolio, individual investors may still care about the specific risk of the securities they hold. Because of wealth constraints or by choice, many investors do not hold diversified portfolios. Those investors might feel the risk of their portfolios has increased when idiosyncratic volatility is rising. Moreover, high idiosyncratic volatility could increase potential total transactions costs if investors with relatively limited means choose to achieve adequate diversification. This is so because an increase in idiosyncratic volatil-ity will have an important effect on increasing the number of securities one must hold to achieve reasonably “full” diversification. Idiosyncratic volatility is also important to arbitrageurs and option traders where total profits depend on total volatility instead of market volatility. Empirically, Malkiel and Xu (2000) have shown that idiosyncratic volatility can explain cross-sectional differences in the returns from individual stocks.
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Investigating the Behavior of Idiosyncratic Volatility
