A Tale of Two Risks: The Role of Time in the Decomposition of Total Risk into Systematic and Idiosyncratic risks

Abstract

Characterizing risk in financial markets has, at times, presented contradictory findings due to differing volatility estimation methodologies. Our research shows that the choice of time intervals in the volatility calculations distinctly captures different aspects of risk, depending on the stock's specific mean-reversion process. Short-interval volatilities predominantly capture idiosyncratic risk, while longer intervals capture systematic risk. This distinction, driven in part by characteristics like mean-reversion rates of the volatility processes, provides deeper insights into the conceptualizations of risk in the asset pricing literature. These findings are vital in categorizing retail traders as noise or informed based on risk.

Keywords: idiosyncratic risk, systematic risk, total risk, retail investors, high frequency trading

JEL Classification: G11, G12, G14, C18, C58