Daily Academic Alpha: Solving the Idiosyncratic Volatility Puzzle
Last updated on January 18th, 2017 at 03:13 pm
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.
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:
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.
Note: This site provides no information on our value investing ETFs or our momentum investing ETFs. Please refer to this site.
Join thousands of other readers and subscribe to our blog.
Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.