Return reversals, idiosyncratic risk, and expected returns

Wei Huang, Qianqiu Liu, Sangghon Rhee, Liang Zhang

Research output: Contribution to journalArticleResearchpeer-review

138 Citations (Scopus)

Abstract

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.
Original languageEnglish
Pages (from-to)147 - 168
Number of pages22
JournalReview of Financial Studies
Volume23
Issue number1
DOIs
Publication statusPublished - 2010
Externally publishedYes

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