The Effect of Investor Attention on the Relationship between Idiosyncratic Volatility and Future Stock Returns

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Hamidian Narges; Fattahi Nafchi Hasan; Rostami Amin; Eshaghi Golnaz

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Journal: Journal of Asset Management and Financing Year:2024 | Volume:12 | Issue:1 Page(s): 1-16

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Title

The Effect of Investor Attention on the Relationship between Idiosyncratic Volatility and Future Stock Returns

Author(s)

Hamidian Narges | Fattahi Nafchi Hasan | Rostami Amin | Eshaghi Golnaz | Issue Writer Certificate

Keywords

Stock return

Idiosyncratic Volatility

investor attention

Abstract

Idiosyncratic volatility of Stock returns is caused by idiosyncratic risk. While proper stock portfolio diversification can mitigate idiosyncratic risk, the precise relationship between Idiosyncratic Volatility and Stock returns remains ambiguous. The present study aims to shed light on this relationship by examining the effect of investor attention. It analyzed a sample of 176 companies listed on the Tehran Stock Exchange from 2016 to 2022. Employing the market model, the authors measured Idiosyncratic Volatility and abnormal trading volume to proxy for investor attention. The findings revealed that Idiosyncratic Volatility exerts a negative and significant impact on future Stock returns. Moreover, it was found that investor attention amplified this negative effect, possibly due to behavioral biases arising from limited attention. Notably, this research diverges from prior studies by emphasizing the role of investor attention, an understudied variable, in shaping the Idiosyncratic Volatility-Stock returns nexus.Keywords: Stock return, Idiosyncratic Volatility, investor attention. IntroductionThe investigation of risk-return relationships has a rich history in financial literature. According to the traditional asset pricing model, only systematic risk significantly impacts asset returns, while idiosyncratic or unsystematic risk that can be eliminated by diversification by the investor does not affect asset returns. However, empirical evidence concerning the link between Idiosyncratic Volatility and Stock returns is ambiguous. Some studies such as Malkiel and Xu (1997), and Goyal and Santa-Clara (2003) find a positive relationship while some other studies such as Ang et al. (2006) and Jiang et al. (2009) document a negative association. Based on previous studies, investor attention can play an important role in shaping stock prices and affect the relationship between Idiosyncratic Volatility and future Stock returns. Therefore, this study aims to investigate the effect of investor attention on the relationship between Idiosyncratic Volatility and future Stock returns. Materials and MethodsTo test the research hypotheses, we utilize multivariate regression models and panel data methods. The sample consists of 176 companies listed on the Tehran Stock Exchange from 2016 to 2022. The independent variable is the Idiosyncratic Volatility of stocks, which is calculated through the market model. In addition, the moderating variable, the investor's attention, has been measured by the abnormal volume.Research FindingsThe empirical findings indicate that Idiosyncratic Volatility has a negative and significant effect on future Stock returns. In other words, the higher the Idiosyncratic Volatility of the Stock return, the lower the future monthly return. Moreover, the investor's attention exacerbates the negative effect of Idiosyncratic Volatility on future Stock returns. That is, the greater investor attention causes the Idiosyncratic Volatility to have a stronger negative effect on future monthly Stock returns. Discussion of Results and ConclusionsThe results of the first hypothesis show that Idiosyncratic Volatility has a negative and significant effect on future returns. In other words, as Idiosyncratic Volatility increases, Stock returns will decrease in the next month. This result is consistent with Ang et al. (2006), Jiang et al. (2009), and Hur and Singh (2022). In the second hypothesis, the effect of investor attention on the negative relationship between Idiosyncratic Volatility and Stock returns was investigated, and it was expected that investor attention would mitigate the negative effect of Idiosyncratic Volatility on future Stock returns. However, the results indicate investor's attention amplifies the negative effect of Idiosyncratic Volatility on future Stock returns. This result diverges from the conclusions drawn by Hur and Singh (2022). This unexpected outcome may be attributed to the behavioral bias associated with limited attention among investors. When attention is constrained, investors may react inaccurately to available information or evaluate it incorrectly, leading to exacerbated negative effects of Idiosyncratic Volatility on future Stock returns.

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