We develop a q-theoretic model of investment under incomplete information that explains the link between idiosyncratic volatility and stock returns. When calibrated to match properties of the US business cycles as well as various firms and industry characteristics, the model generates a negative...

When investors have incomplete information, expected returns, as measured by an econometrician, deviate from those predicted by standard asset pricing models by including a term that is the product of the stock’s idiosyncratic volatility and the investors’ aggregated forecast errors. If...