Idiosyncratic Volatility, Stock Market Volatility, and Expected Stock Returns

We show that the value-weighted idiosyncratic stock volatility and aggregate stock market volatility jointly exhibit strong predictive abilities for excess stock market returns, although they don't do so individually. While we uncover a positive risk-return relation in the stock market, as stipulated by the CAPM, the idiosyncratic volatility is negatively related to future stock returns. One potential explanation for the latter result is that the idiosyncratic volatility is a measure of divergence of opinion, which, as argued by Miller (1977), could lead a stock to be overvalued initially and to suffer capital losses subsequently. However, we find that the idiosyncratic volatility forecasts stock returns mainly because of its negative co-movements with the consumption-wealth ratio, which, as argued by some recent authors, is a proxy for the liquidity premium