High Idiosyncratic Volatility and Low Returns: A Prospect Theory Explanation
Financial Management, Forthcoming.
44 Pages Posted: 15 May 2011 Last revised: 3 Apr 2014
Date Written: May 13, 2011
The well-documented negative relationship between idiosyncratic volatility and stock returns is puzzling if investors are risk-averse. However, under prospect theory, while investors are risk-averse in the domain of gains, they exhibit risk-seeking behavior in the domain of losses. Consistent with risk-seeking investors’ preference for high volatility stocks in the loss domain, we find that the negative relationship between idiosyncratic volatility and stock returns is concentrated in stocks with unrealized capital losses, but is non-existent in stocks with unrealized capital gains. This finding is robust to control for short-term return reversals and maximum daily return, among other variables.
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