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Return Reversals, Idiosyncratic Risk, and Expected Returns

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  • Wei Huang
  • Qianqiu Liu
  • S. Ghon Rhee
  • Liang Zhang

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. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Suggested Citation

  • Wei Huang & Qianqiu Liu & S. Ghon Rhee & Liang Zhang, 2010. "Return Reversals, Idiosyncratic Risk, and Expected Returns," The Review of Financial Studies, Society for Financial Studies, vol. 23(1), pages 147-168, January.
    • Handle: RePEc:oup:rfinst:v:23:y:2010:i:1:p:147-168
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    File URL: http://hdl.handle.net/10.1093/rfs/hhp015
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