The Cross-Section of Volatility and Expected Returns
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What they found
The authors sorted U.S. stocks by their idiosyncratic volatility (the part of daily return variation not explained by market and factor moves) from 1963 to 2000 and found a result that contradicts intuition: the most volatile stocks earned dramatically lower subsequent returns than the least volatile, by around 1% per month. They also showed that stocks with high sensitivity to changes in aggregate volatility earn lower returns, consistent with investors paying a premium for assets that do well when volatility spikes.
What you can use
- The most volatile individual stocks, the ones that attract retail attention, have historically had the worst returns.
- Being long high-volatility names is a bet that has lost on average; that is the flip side of the low-volatility premium.
- Assets that pay off when volatility rises are expensive; expect low returns for holding hedges.
Caveats
The 'idiosyncratic volatility puzzle' is sensitive to how volatility is measured and the weighting scheme; some argue it is driven by short-term reversal and microcaps. Gross of costs and shorting constraints.
Tags: factor, volatility, low-volatility, anomalies
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.