Retail Clienteles and the Idiosyncratic Volatility Puzzle

Abstract

This study examines whether the puzzling negative relation between idiosyncratic volatility and expected returns (Ang, Hodrick, Xing, and Zhang (2006, 2008)) is influenced by the preferences and the trading behavior of volatility-seeking retail investors. First, we show that volatility-seeking retail clienteles exist. Retail investors prefer to hold and actively trade high idiosyncratic volatility stocks due to their greater propensity to speculate or gamble (Dorn and Huberman (2007)) and also because those stocks offer a greater opportunity for experiencing higher levels of realization utility (Barberis and Xiong (2008)). In contrast, institutional investors prefer low idiosyncratic volatility stocks. Next, we show that the negative return-volatility relation is concentrated among stocks that are actively traded by retail investors and exhibit strong speculative characteristics (e.g., high idiosyncratic skewness). Among stocks with low levels of retail trading, future returns increase with idiosyncratic volatility. Collectively, our results indicate that the level of retail trading is a critical determinant of the volatility-return relation.