Have We Solved the Idiosyncratic Volatility Puzzle?
Charles A. Dice Center Working Paper No. 2012-28
63 Pages Posted: 18 Dec 2012 Last revised: 2 Oct 2015
Date Written: September 1, 2015
We propose a simple methodology to evaluate a large number of potential explanations for the negative relation between idiosyncratic volatility and subsequent stock returns (the idiosyncratic volatility puzzle). We find that surprisingly many existing explanations explain less than 10% of the puzzle. On the other hand, explanations based on investors’ lottery preferences and market frictions show some promise in explaining the puzzle. Together, all existing explanations account for 29-54% of the puzzle in individual stocks and 78-84% of the puzzle in idiosyncratic volatility-sorted portfolios. Our methodology can be applied to evaluate competing explanations for other asset pricing anomalies.
Keywords: idiosyncratic volatility, cross-section of stock returns, lottery preferences, market frictions
JEL Classification: G12, G14
Suggested Citation: Suggested Citation