Abstract
We investigate the relationship between IPO long-run underperformance ( Ritter, 1991 ; Loughran and Ritter, 1995 ) and the idiosyncratic risk puzzle ( Ang, Hodrick, Xing, and Zhang, 2006 ) or the phenomenon of abnormally low returns for stocks with high idiosyncratic risk. We find that IPO long-run underperformance is a manifestation of surprisingly low returns for high idiosyncratic risk stocks. IPO underperformance disappears after we control for idiosyncratic risk. On the other hand, we find that the idiosyncratic risk puzzle is magnified by IPO underperformance. Our results are robust to various specifications or sample requirements. We evaluate a couple of potential common causes for the two puzzles and conclude that investors’ preferences for stocks with lottery features is the primary mechanism linking the two puzzles.
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