Does Idiosyncratic Volatility Proxy for a Missing Risk Factor? Evidence Using Portfolios as Test Assets

One of the main explanations for the idiosyncratic volatility (IVOL) puzzle (i.e., the negative relation between lagged IVOL and returns) is a missing risk factor. We show analytically that if IVOL proxies for a missing risk factor, then the negative relation between IVOL and returns should persist at the portfolio level. Empirically, we find that the IVOL puzzle disappears when we use well-diversified portfolios as test assets. The IVOL puzzle also weakens after controlling for additional risk factors. Overall, our results suggest that both diversifiable (i.e., true idiosyncratic risk) and non-diversifiable risk play a role in explaining the IVOL puzzle.