of securities, the number of estimates required for the Markowitz procedure using the index model is only a small fraction of what otherwise would he needed. Another advantage is less obvious but equally important. The index model abstraction is crucial for specialization of effort in security analysis. If a covariance term had to be cal- culated directly for each security pair, then security analysts could not specialize by indus- try. For example, if one group were to specialize in the computer industry and another in the auto industry, who would have the common background to estimate the covariance be- tween IBM and GM? Neither group would have the deep understanding of other industries necessary to make an informed judgment of co-movements among industries. In contrast, the index model suggests a simple way to compute covariances. Covariances among secu- rities are due to the influence of the single common factor, represented by the market index return, and can be easily estimated using equation 10.4. The simplification derived from the index model assumption is, however, not without cost. The "cost" of the model lies in the restrictions it places on the structure of asset return uncertainty. The classification of uncertainty into a simple dichotomy-macro versus mi- cro risk-oversimplifies sources of real-world uncertainty and misses some important sources of dependence in stock returns. For example, this dichotomy rules out industry events, events that may affect many firms within an industry without substantially affect- ing the broad macroeconomy. Statistical analysis shows that relative to a single index, the firm-specific components of some firms are correlated. Examples are the nonmarket components of stocks in a single industry, such as computer stocks or auto stocks. At the same time, statistical significance does not always correspond to economic significance. Economically speaking, the question that is more relevant to the assumption of a single-index model is whether portfolios con- structed using covariances that are estimated on the basis of the single-factor or single- index assumption are significantly different from, and less efficient than, portfolios constructed using covariances that are estimated directly for each pair of stocks. We ex- plore this issue further in Chapter 28 on active portfolio management.             CONCEPT C H E C K ☞ QUESTION 1 Suppose that the index model for stocks A and B is estimated with the following results:   RA 1.0% .9RM eA RB 2.0% 1.1RM eB M 20% (eA) 30% (eB) 10%