Idiosyncratic (also referred to as nonsystematic) risk is specific to a single asset or to a small group of assets. Idiosyncratic risk has little or no correlation with market risk. Therefore, it can be substantially mitigated or eliminated by sufficiently diversifying a portfolio. Because it can be mitigated, investors aren’t rewarded with higher expected returns for taking idiosyncratic risk.
In fact, one of the major anomalies (or “puzzles”) in finance is that stocks with greater idiosyncratic volatility (IVOL) have produced lower returns. This represents an anomaly because idiosyncratic volatility is viewed as a risk factor—greater volatility should be rewarded with higher, not lower, returns.
Robert Stambaugh, Jianfeng Yu and Yu Yuan, authors of the 2015 study “Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle,” which appeared in The Journal of Finance, provide an explanation, and the evidence supporting it, for why the anomaly persists.
They begin with the hypothesis that IVOL represents risk that deters arbitrage and its resulting reduction of mispricings. The authors then combine this concept with what they term “arbitrage asymmetry,” which is the greater ability and/or willingness of investors to take a long position as opposed to taking a short position when they perceive mispricing in a security. This asymmetry occurs because there are greater risks and costs involved in shorting, including the potential for unlimited losses.
In addition to the greater risks and costs associated with shorting, for stocks with a low level of institutional ownership, there may not be sufficient shares available to borrow in order for investors to sell them short. Because institutions are the primary lenders of securities, studies have found that when institutional ownership is low, the supply of stocks available to loan tends to be sparse. As a result, short-selling tends to be more expensive.
Furthermore, the charters of many institutions prevent (or severely limit) shorting. And finally, there is the risk that adverse moves in security prices can force capital-constrained investors to reduce their short positions before realizing the profits that would ultimately result from the correction of the mispricing. Importantly, when IVOL is higher, substantial adverse price moves are more likely.
The authors write: “Combining the effects of arbitrage risk and arbitrage asymmetry implies the observed negative relation between IVOL and expected return.” And that is exactly the result they found. Specifically, “the IVOL effect is significantly negative (positive) among the most overpriced (underpriced) stocks and the negative effect among the overpriced stocks is significantly stronger—the negative highest-versus-lowest difference among the most overpriced stocks is 3.7 times the magnitude of the corresponding positive difference among the most underpriced stocks.”