Idiosyncratic volatility shocks, behavior bias, and cross-sectional stock returns

This paper examines the impact of idiosyncratic volatility (IV) shocks on cross-sectional stock returns. The IV shock is defined by comparing a stock’s idiosyncratic volatility in month t against its own idiosyncratic volatilities estimated in the previous months. The results indicate that stocks with positive (negative) IV shocks subsequently underperform (outperform). Unlike the conventional cross-sectional sorts on the level of IV, the intertemporal IV shocks identified in this paper are better served to capture the very moment when firm specific information arrives or is fully absorbed. Therefore, the performance divergence between stocks with positive and negative IV shocks reflects how investors interpret the new information. We document that cognitive bias, such as the disposition effect and gambler’s fallacy, may provide a reasonable explanation for the IV shock effect.