High Idiosyncratic Volatility and Low Returns: A Prospect Theory Explanation

Authors

  • Ajay Bhootra,

  • Jungshik Hur

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    • Ajay Bhootra is an Assistant Professor of Finance in the Mihaylo College of Business and Economics at California State University in Fullerton, CA. Jungshik Hur is an Assistant Professor of Finance in the Department of Economics and Finance at Louisiana Tech University in Ruston, LA.


  • We thank Marc Lipson (Editor) and an anonymous referee for many suggestions that led to significant improvements. We are grateful to Bing Han, David Hirshleifer, Greg Kadlec, Vijay Singal, and seminar participants at the 2011 FMA annual meetings and the 2013 California Corporate Finance Conference at Loyola Marymount University for helpful suggestions. We thank Ken French and Jeff Wurgler for providing the Fama-French factors and the sentiment index, respectively, on their websites.

Abstract

The well-documented negative relationship between idiosyncratic volatility and stock returns is puzzling if investors are risk-averse. However, under prospect theory, while investors are risk-averse in the domain of gains, they exhibit risk-seeking behavior in the domain of losses. Consistent with risk-seeking investors’ preference for high-volatility stocks in the loss domain, we find that the negative relationship between idiosyncratic volatility and stock returns is concentrated in stocks with unrealized capital losses, but is nonexistent in stocks with unrealized capital gains. This finding is robust to control for short-term return reversals and maximum daily return, among other variables.

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