Have we solved the idiosyncratic volatility puzzle?

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). Surprisingly, we find that many existing explanations explain less than 10% of the puzzl...

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Bibliographic Details
Published in:Journal of financial economics 2016-07, Vol.121 (1), p.167-194
Main Authors: Hou, Kewei, Loh, Roger K.
Format: Article
Language:English
Subjects:
Correlation analysis
Cross-section of stock returns
Idiosyncratic volatility
Lottery preferences
Market frictions
Rates of return
Research methodology
Securities prices
Studies
Volatility
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Summary: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). Surprisingly, we find that many existing explanations explain less than 10% of the puzzle. On the other hand, explanations based on investors’ lottery preferences and market frictions show some promise in explaining the puzzle. Together, all existing explanations account for 29–54% of the puzzle in individual stocks and 78–84% of the puzzle in idiosyncratic volatility-sorted portfolios. Our methodology can be applied to evaluate competing explanations for other asset pricing anomalies.
ISSN:0304-405X
1879-2774
DOI:10.1016/j.jfineco.2016.02.013