Investor Overconfidence and the Increase in Idiosyncratic Risk

Abstract

This paper examines the relation between investor overconfidence and the idiosyncratic volatility of stock returns. We use investor sentiment, stock turnover, stock misvaluation, and institutional ownership to measure the influence of investor overconfidence on stocks, and find that idiosyncratic volatility is correlated with investor overconfidence proxies in both cross-sectional and time-series tests. The results are robust when other well-documented determinants of idiosyncratic volatility such as firm size, age, stock price, profitability, and growth options are controlled. We thus conclude that investor overconfidence contributes to the dynamics of idiosyncratic volatility both across stocks and over time.

Keywords: Overconfidence, Idiosyncratic Risk

JEL Classification: D82, D83, G12, G14