Return Reversals, Idiosyncratic Risk, and Expected Returns
37 Pages Posted: 13 Jan 2009
Date Written: January 11, 2009
The empirical evidence on the cross-sectional relation between idiosyncratic risk and expected stock returns is mixed. We demonstrate that the omission of the previous month's stock returns can lead to a negatively biased estimate of the relation. The magnitude of the omitted variable bias depends on the approach to estimating the conditional idiosyncratic volatility. Although a negative relation exists when the estimate is based on daily returns, it disappears after return reversals are controlled for. Return reversals can explain both the negative relation between value-weighted portfolio returns and idiosyncratic volatility and the insignificant relation between equal-weighted portfolio returns and idiosyncratic volatility. In contrast, there is a significantly positive relation between the conditional idiosyncratic volatility estimated from monthly data and expected returns. This relation remains robust after controlling for return reversals.
Keywords: return reversal, idiosyncratic risk, expected return
JEL Classification: G12, C13
Suggested Citation: Suggested Citation