RFS Advance Access published online on March 25, 2009
Review of Financial Studies, doi:10.1093/rfs/hhp015
Return Reversals, Idiosyncratic Risk, and Expected Returns
Shidler College of Business, University of Hawaii at Manoa
Shidler College of Business, University of Hawaii at Manoa
SKKU Business School (Korea) and Shidler College of Business, University of Hawaii at Manoa
Faculty of Economics and Commerce, University of Melbourne
Send correspondence to Qianqiu Liu, Shidler College of Business, University of Hawaii at Manoa, 2404 Maile Way, Honolulu, HI 96822; telephone: 808-956-8736; fax: 808-956-9887. E-mail: qianqiu{at}hawaii.edu.
JEL Classification: G12, C13
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Abstract |
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The empirical evidence on the cross-sectional relation between idiosyncratic risk and expected stock returns is mixed. We demonstrate that the omission of the previous month's stock returns can lead to a negatively biased estimate of the relation. The magnitude of the omitted variable bias depends on the approach to estimating the conditional idiosyncratic volatility. Although a negative relation exists when the estimate is based on daily returns, it disappears after return reversals are controlled for. Return reversals can explain both the negative relation between value-weighted portfolio returns and idiosyncratic volatility and the insignificant relation between equal-weighted portfolio returns and idiosyncratic volatility. In contrast, there is a significantly positive relation between the conditional idiosyncratic volatility estimated from monthly data and expected returns. This relation remains robust after controlling for return reversals.
We thank an anonymous referee and Matthew Spiegel (the editor) for providing many valuable comments that helped us significantly improve the article. We are also grateful for useful comments from Zhi Da, Jack De Jong, David McLean, Greg Stone, Zhe Zhang, and the seminar and conference participants at Peking University, Sun Yat-sen University, University of New South Wales, University of Tokyo, Xiamen University, 2006 Financial Management Association Annual Meeting, 2007 China International Conference in Finance, 2007 European Financial Management Association Annual Meeting, and 2008 AsianFA-NFA International Conference. All errors are ours.