Daily Academic Alpha: Solving the Idiosyncratic Volatility Puzzle

Daily Academic Alpha: Solving the Idiosyncratic Volatility Puzzle

November 19, 2015 Uncategorized

Last updated on January 18th, 2017 at 03:13 pm

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Kewei Hou and Roger Loh have a fun paper on the idiosyncratic volatility puzzle, which is set to be published in the Journal of Financial Economics. The idiosyncratic volatility puzzle is associated with the empirical evidence which suggests that stocks with higher idiosyncratic volatility (volatility left over after controlling for “systematic” risk factors) earn lower returns. Rough cut finance theory would suggest 1) that the relationship should be flat because investors can hold well diversified portfolios and thus, idiosyncratic, or random, volatility washes away, or 2) the relationship should be positive because investors need to price idiosyncratic volatility because it is costly to be completely diversified. Readers can learn more on volatility anomalies here.

Hou and Loh try and solve the puzzle and determine that the anomaly is likely driven by an assortment of behavioral biases and market frictions that create limits of arbitrage. However, they conclude that the puzzle is still puzzling.

Have We Solved the Idiosyncratic Volatility Puzzle?

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 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.

First, the evidence on the puzzle, which shows the negative relationship between ivol and returns, even after controlling for everything under the sun:

ivol puzzle
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

And next comes their decomposition to try and understand what is going on. There is a lot to be explained, but behavioral reasons and market frictions are the most plausible explanations.

ivol puzzle contributions
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.