Abstract
AbstractOne 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.
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