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Have We Solved the Idiosyncratic Volatility Puzzle?

  • Hou, Kewei

    (OH State University)

  • Loh, Roger

    (Singapore Management University)

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, short-term return reversal, and earnings shocks show greater promise in explaining the puzzle. Together they account for 60-80% of the negative idiosyncratic volatility-return relation. Our methodology can be applied to evaluate competing explanations for a broad range of topics in asset pricing and corporate finance.

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Paper provided by Ohio State University, Charles A. Dice Center for Research in Financial Economics in its series Working Paper Series with number 2012-28.

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Date of creation: Dec 2012
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Handle: RePEc:ecl:ohidic:2012-28
Contact details of provider: Phone: (614) 292-8449
Web page: http://www.cob.ohio-state.edu/fin/dice/list.htm
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