High Idiosyncratic Volatility and Low Returns: A Prospect Theory Explanation

Financial Management, Forthcoming.

44 Pages Posted: 15 May 2011 Last revised: 3 Apr 2014

See all articles by Ajay Bhootra

Ajay Bhootra

California State University, Fullerton

Jungshik Hur

Louisiana Tech University

Date Written: May 13, 2011

Abstract

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.

Suggested Citation

Bhootra, Ajay and Hur, Jungshik, High Idiosyncratic Volatility and Low Returns: A Prospect Theory Explanation (May 13, 2011). Financial Management, Forthcoming. , Available at SSRN: https://ssrn.com/abstract=1840748 or http://dx.doi.org/10.2139/ssrn.1840748

Ajay Bhootra (Contact Author)

California State University, Fullerton ( email )

Mihaylo College of Business and Economics
P.O. Box 6848
Fullerton, CA Orange 92834
United States

Jungshik Hur

Louisiana Tech University ( email )

P.O. Box 3178
Ruston, LA 71272
United States
318-257-3558 (Phone)
318-257-4253 (Fax)

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