Kewei Hou, Roger K. Loh
Journal of Financial Economics 121(1), 167–194 (2016).
Kewei Hou, Roger K. Loh. Have We Solved the Idiosyncratic Volatility Puzzle? Journal of Financial Economics 121(1), 167–194 (2016).
IN ONE SENTENCE:
The paper develops a statistical decomposition method to compare explanations for why stocks with greater firm-specific volatility earn lower subsequent returns, finding that investors’ preference for lottery-like stocks is among the most promising explanations.
Abstract:
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). Surprisingly, we find that 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.
Other Links/Materials:
SSRN / paper | Journal / DOI | Slides
Alpha Architect: Solving the Idiosyncratic Volatility Puzzle, November 2015 — Practitioner coverage
Keywords:
Idiosyncratic volatility · Asset-pricing anomalies · Lottery preferences · Market frictions · Empirical asset pricing · Firm-specific risk · Cross-section of stock returns · Anomaly decomposition