Abstract
We provide empirical evidence for the incomplete information model advanced by Merton (1987), which shows that the relation between idiosyncratic volatility (IV) and expected return is conditional on the firm’s investor base. Using four different proxies for investor base, we show that idiosyncratic risk premiums are larger for neglected stocks, and smaller or even economically insignificant for visible stocks. Since neglected stocks have greater IV, the total IV risk premium (price times quantity) for neglected stocks will be greater than for visible stocks. Additionally, we find a positive size effect and negative beta effect after controlling for IV, which are both consistent with Merton’s model predictions. Overall, our results provide strong support for the theory that the market segmentation induced by incomplete information is an important component of the documented influence of IV in the cross-section of returns.
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