The Joint Effect of Idiosyncratic Volatility and Investor Sentiment on the Cross Section of Stock Returns

This paper examines stock returns by incorporating idiosyncratic volatility with the information contained inside the two channels of Baker and Wurgler (2006) in explaining investor sentiment effects on the cross-sectional returns. We provide empirical evidence to show that the joint effect of idiosyncratic volatility (IVOL) and investor sentiment (SENTA) positively relates to the cross-section of stock returns contemporaneously. Our joint factor performs better within stocks with smaller size, higher IVOL and extreme SENTA*IVOL. The significantly negative pricing power of SENTA*IVOL is crowded in the lowest SENTA portfolio. By contrast, the significantly stronger positive power is concentrated in the highest SENTA portfolio. The impact of the interaction highlights the positive idiosyncratic volatility-return relation detected in our sample and is insusceptible from different exclusion schemes and business cycles