Idiosyncratic Risk Matters to Large Stocks!

Abstract

Despite the debate on the pricing of idiosyncratic risk, it is generally believed that the pricing effect is likely to exist among small stocks due to lack of diversification and information asymmetry predicted by Merton (1987). However, given the size of Asset Under Management, most institutional investors focus on large stocks and hold portfolios different from that of the market portfolio in order to attract investors and to differentiate themselves. Moreover, large stocks will have a larger impact on the performance of a portfolio than small stocks, and institutional investors are more likely to be questioned when large stocks perform poorly. These unique features can forced institutional investors to care about idiosyncratic risk of larger stocks more than that of small stocks in their portfolio. Recognizing this important difference on the impact of idiosyncratic risk, we take an unorthodox approach by focusing on the effect of idiosyncratic risk within different groups of stocks. As a result, we find that large stocks’ idiosyncratic volatilities indeed are positively related to their future stock returns, while small stocks idiosyncratic volatilities are negatively related to their future returns as documented. This finding also allows us to reconcile the inconsistent findings on the pricing of idiosyncratic risk in the current literature.