Risk Management: Foundations for a Changing Financial World

CHAPTER 20

WHY COMPANY-SPECIFIC RISK CHANGES OVER TIME^t

James A. Bennett, CFA, and Richard W. Sias

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.

A number of recent studies [e.g., Campbell, Lettau, Malkiel, and Xu 2001 (henceforth, CLMX); Morck, Yeung, and Yu 2000; Goyal and Santa-Clara 2003] have demonstrated that, although market and industry risk remained relatively stable in the U.S. market between the early 1960s and the late 1990s, company-specific risk climbed steadily throughout the period. In addition, as we demonstrate in this study, company-specific risk has exhibited a secular decline since the market peak in 2000.

Changes in company-specific risk over time affect portfolio managers for a number of reasons. First, company-specific risk is directly related to portfolio diversification: Active managers attempting to achieve some given level of company-specific ...