Separating Up from Down: New Evidence on the Idiosyncratic Volatility - Return Relation
43 Pages Posted: 20 Mar 2007 Last revised: 21 Feb 2013
Date Written: July 1, 2007
The finding that stocks with high idiosyncratic volatility tend to have low future returns has been dubbed an empirical anomaly in the finance literature. We seek to understand this puzzle by separating the upside volatility associated with positive idiosyncratic returns from the downside risk associated with negative idiosyncratic returns. We find that downside risk is not inversely related to future stock returns, thus easing the concern that the empirical anomaly is a mispricing of risk. Rather, our results suggest that it is upside volatility that drives the inverse idiosyncratic volatility and return relation. We further examine whether the relation of future returns with downside and upside volatility accords with investor underreaction to bad news and overreaction to good news. Finally, we show that momentum strategies may be enhanced by taking into account stocks' upside volatility.
Keywords: idiosyncratic volatility, risk
JEL Classification: G12
Suggested Citation: Suggested Citation