Does idiosyncratic volatility proxy for a missing risk factor? Evidence using portfolios as test assets

One of the main explanations for the idiosyncratic volatility (IVOL) puzzle (i.e., the negative relation between lagged IVOL and returns) is a missing risk factor. We show, analytically, that if IVOL proxies for a missing risk factor, then the negative relation between IVOL and returns should persist at the portfolio level. Empirically, we find that the IVOL puzzle disappears when we use well-diversified portfolios as test assets. The IVOL puzzle also weakens after controlling for additional risk factors. Overall, our results suggest that both diversifiable (i.e., true idiosyncratic risk) and nondiversifiable risk play a role in explaining the IVOL puzzle.

Automated summary

This study found that the idiosyncratic volatility (IVOL) puzzle disappears when well-diversified portfolios are used as test assets, and weakens after controlling for additional risk factors. The results suggest that both diversifiable and nondiversifiable risk play a role in explaining the IVOL puzzle.