Common idiosyncratic volatility and returns: From an investment horizon perspective

“Idiosyncratic risk–return puzzle” is conflicting and confusing. It becomes more complex by the introduction of the common idiosyncratic volatility (CIV). We shed new light on the issue from the perspective of heterogeneity of investors with different investment horizons. We study the “CIV puzzle” with Chinese A‐Share market evidence and further contribute by employing the wavelet multiresolution analysis framework to decompose the overall CIV into timescales that refer to risks in different terms. We apply these timescales in Fama–Macbeth regressions to investigate their pricing effects. The results suggest that the “CIV puzzle” is an investment horizon specification problem. The relationship between returns and common idiosyncratic risk is negative in the short run, positive in the intermediate run, and then negative again in the longer run. We also contribute to the international empirical evidence with an in‐depth analysis of the Chinese stock market over the period 1999–2016. The results are robust across different specifications of the CIV. Our findings have important implications for portfolio and risk management.