Have we Solved the Idiosyncratic Volatility Puzzle?

• Main Authors: HOU, Kewei, LOH, Roger
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2016
• Subjects: idiosyncratic volatility; cross-section of stock returns; lottery preferences; market frictions; Corporate Finance; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/3503; https://ink.library.smu.edu.sg/context/lkcsb_research/article/4502/viewcontent/HouLohRoger_22Sep2015_IdiosyncraticVolatilityPuzzle.pdf
• Institution: Singapore Management University

We propose a simple methodology to evaluate a large number of potential explanations for the negative relation between idiosyncratic volatility and subsequent stock returns (the idiosyncratic volatility puzzle). We find that surprisingly many existing explanations explain less than 10% of the puzzle. On the other hand, explanations based on investors’ lottery preferences, short-term return reversal, and earnings shocks show greater promise in explaining the puzzle. Together they account for 60-80% of the negative idiosyncratic volatility-return relation. Our methodology can be applied to evaluate competing explanations for a broad range of topics in asset pricing and corporate finance.