Short-Sale Constraints and the Non-January Idiosyncratic Volatility Puzzle

The underperformance of high idiosyncratic volatility stocks, as documented by Ang, Hodrick, Ying, and Zhang (2006, JF), is a pure non-January phenomenon. This non-January negative relation between idiosyncratic volatility and stock returns is more pronounced among firms with greater constraints in short selling, and when short-sale constraints are mitigated from the introduction of options and the end of the IPO lockup period. Apart from an average underperformance, highly volatile stocks also have the greatest dispersion in expected returns and in price reactions around earnings announcements. These findings support behavioral models suggesting that noise trading and investor overconfidence, combined with short-sale constraints, generate excess volatility, greater mispricing, and on average lower expected returns.