Idiosyncratic Risk and the Cross-Section of Stock Returns: Merton (1987) Meets Miller (1977)

Abstract:     
Merton (1987) predicts that idiosyncratic risk should be priced when investors hold sub-optimally diversified portfolios, but empirical research has not been supportive of the theory. An overlooked assumption in Merton (1987) is that the predictions are predicated on frictionless markets, and in particular an absence of short-sale constraints. We examine the cross-sectional effects of idiosyncratic risk (and dispersion of beliefs) while controlling for short-sale constraints. We find that when short-sale constraints are absent, both idiosyncratic risk and dispersion of analyst forecasts are positively correlated with future abnormal returns; a result consistent with Merton (1987). However, when short-sale constraints are present the correlation becomes negative: increased analyst dispersion and idiosyncratic volatility produce negative abnormal returns, consistent with Miller (1977). This can explain the inconsistent empirical findings in the previous literature, which casts Merton (1987) and Miller (1977) as competing hypotheses.

Keywords: Idiosyncratic volatility, expected returns

JEL Classifications: G12

Working Paper Series