Idiosyncratic Volatility, Stock Market Volatility, and Expected Stock Returns

Abstract

We find that the value-weighted idiosyncratic stock volatility and aggregate stock market volatility jointly exhibit strong predictive power for excess stock market returns. The stock market risk–return relation is found to be positive, as stipulated by the capital asset pricing model; however, idiosyncratic volatility is negatively related to future stock market returns. Also, idiosyncratic volatility appears to be a pervasive macrovariable, and its forecasting abilities are very similar to those of the consumption–wealth ratio proposed by Lettau and Ludvigson.

KEY WORDS:

• Consumption–wealth ratio
• Dispersion of opinion
• Intertemporal capital asset pricing model
• Out-of-sample forecast
• Stock market risk-return relation
• Stock return predictability