Dr Jisok Kang, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance
Ever since the Capital Asset Pricing Model (CAPM) was first introduced in 1964, a well-accepted conception in the modern portfolio theory is that the market portfolio contains only market risk or systematic risk as firm-specific risk or non-systematic risk is diversified away.
Meanwhile, Xavier Gabaix, in a paper published at Econometrica in 2011 titled as “The Granular Origins of Aggregate Fluctuations”, argues that idiosyncratic firm-specific shocks to large firms in an economy can explain a great portion of the variation in macro-economic movements if firm size distribution is fat-tailed. His argument implies that firm-specific shocks to large firms are granular in nature and may not be easily diversified away. He empirically shows that idiosyncratic movements by the largest 100 firms in the U. can explain roughly one third of the variation in the GDP growths of the country, the phenomenon he dubs “the granular effect”.
Jisok Kang, a CERF research associate, in his recent research paper, shows that stock market concentration, the level of domination by the largest firms in the stock market, increases the volatility of market portfolio. This finding implies that the idiosyncratic, firm-specific risk of large firms is granular in nature and not diversified away in the market portfolio. This finding is robust whether the market portfolio volatility is defined with value-weighted or equal-weighted index.
In addition, stock market concentration causes other stock prices to co-move thus increases the market portfolio volatility further. The incremental volatility caused by stock market concentration is bad volatility in that the effect is severer when the market portfolio return is negative.