Bali and Cakici (2006) find no relation between equally-weighted portfolio returns and idiosyncratic risk, whereas Ang et al. (2006a) report a negative relation between value-weighted portfolio returns and idiosyncratic risk. Our analyses demonstrate that both findings can be explained by short-term monthly return reversals. The abnormal positive returns from taking a long (short) position in the low (high) idiosyncratic risk portfolio are fully explained by an additional control variable, the “winners minus losers” portfolio returns,introduced to the conventional three- or four- factor time-series regression model. The cross-sectional regressions also confirm that no robust and significant relation exists between idiosyncratic risk and expected returns once we control for return reversals.
Whether idiosyncratic risk is priced in asset returns has been the subject of considerable attention in recent years due to its critical importance in asset pricing and portfolio allocation. This issue has gained further importancegiven the recent evidence that both firm-level volatility and the number of stocks needed to achieve a specific level of diversification have increased in the United States over time [Campbell et al. (2001)]. The empirical results reported so far are mixed. Consistent with earlier research such as Lehmann (1990a), Lintner (1965), Tinic and West (1986), and Merton (1987), a number of recent studies report a significant positive relation between idiosyncratic risk and expected stock returns, either at the aggregate level [Goyal and Santa-Clara (2003), Jiang and Lee (2005)], or at the firm or portfolio level [Malkiel and Xu (2002), Fu (2005), Spiegel and Wang (2005), Chua et el. (2006)]. Other studies, however, do not support this positive relation. For example, in their classic empirical asset pricing study, Fama and MacBeth (1973) document that the statistical significance of idiosyncratic risk is negligible. Bali et al. (2005) find that the positive relation documented by Goyal and Santa-Clara (2003) at the aggregate level is not robust. Guo and Savickas (2006) report a negative relation between aggregate stock market idiosyncratic volatility and the future quarterly stock market return.
In a recent study, Ang et al. (2006a) examine the relationship between idiosyncratic risk and the future stock return at the portfolio level. Specifically, they form portfolios sorted by idiosyncratic risk of individual stocks defined relative to the Fama and French (1993) three-factor model. They find that portfolios with high idiosyncratic volatility in the current month yield low returns in the following month and the difference between the value weighted return on the portfolio with the highest idiosyncratic risk and the return on the portfolio with the lowest idiosyncratic risk is -1.06% per month on average. They therefore conclude that there is a negative intertemporal relation between realized idiosyncratic risk and future stock returns. Ang et al. (2006b) also confirm this negative relation in international markets and observe strong co-movement among stocks with high idiosyncratic risk across countries.
In a related study, however, Bali and Cakici (2006) find that the negative relation between idiosyncratic volatility and expected returns is not robust under different weight scheme to calculate average portfolio returns. They find that there is no significant difference between the equally-weighted quintile portfolio returns, when the idiosyncratic volatility sorted quintile portfolios are constructed using the same approach as in Ang et al. (2006a).
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Return Reversals, Idiosyncratic Risk and Expected Returns
