Idiosyncratic volatility and the cross-section of abnormal returns in Pakistan: Evidence from a country with religious bans on lotteries and substantive institutional investor participation

The idiosyncratic volatility (IVOL) puzzle has been associated with individual investors’ preference toward lottery-like stocks, causing mispricings. Existing studies that relate the negative IVOL premium with social-religious acceptance of gambling do not simultaneously control for investor-type composition and religious bans. This study provides a natural experiment from Pakistan, where gambling and lotteries are religiously prohibited and the stock market is not dominated by individual investors. We find that the IVOL effect substantially weakens in Pakistan. Furthermore, consistent with our conjecture, stocks investable by Islamic funds significantly differ in terms of IVOL premia. In further analysis, partitioning stocks based on past abnormal returns in the spirit of prospect theory, we find no monotonic relation, but discover that the lowest-IVOL stocks rebound following past negative returns and the highest-IVOL stocks underperform following past positive returns. The latter suggests that a sentiment-driven interaction of chasing and gambling behaviors may be in action. Zero-investment portfolios that buy (sell) long (short) legs of the selected mispricing anomalies with the highest IVOL significantly outperform original strategies. Finally, constructing a mispricing factor and mispricing-augmented factor models, we examine whether the IVOL premium is attributable to risk or mispricing, and find that the IVOL effect interacts with mispricing.