Return reversals, idiosyncratic risk, and expected returns

Bali and Cakici (2006) find no relation between equally-weighted portfolio returns and idiosyncratic risk, whereas Ang et al. (2006a) report a negative relation between value-weighted portfolio returns and idiosyncratic risk. Our analyses demonstrate that both findings can be explained by short-term monthly return reversals. The abnormal positive returns from taking a long (short) position in the low (high) idiosyncratic risk portfolio are fully explained by an additional control variable, the “winners minus losers ” portfolio returns, introduced to the conventional three- or four-factor time-series regression model. The cross-sectional regressions also confirm that no robust and significant relation exists between idiosyncratic risk and expected returns once we control for return reversal