Aggregate Idiosyncratic Volatility, Dynamic Aspects of Loss Aversion, and Narrow Framing

Abstract

We test the dynamic aspects of the loss aversion feature of Kahneman and Tversky (1979) and find that idiosyncratic volatility is negatively associated with unrealized gains of stock returns. Moreover, we show that this negative relationship is stronger for stocks with high individual investors’ holdings. Finally, we show that controlling for firm age as defined by Fink et al (2010) eliminates the significance of retail trading proportions as a driver of idiosyncratic volatility. These findings are robust to price, sentiment, and IPO dates. Bivariate vector auto-regression (VAR) confirms the causality of unrealized gains of stock returns on idiosyncratic volatility.

Keywords: Loss Aversion; Narrow Framing

JEL Classification: G11; G12