Have we solved the idiosyncratic volatility puzzle?

We propose a simple methodology to evaluate a large number of potential explanations for the negative relation between idiosyncratic volatility and subsequent stock returns (the idiosyncratic volatility puzzle). Surprisingly, we find that many existing explanations explain less than 10% of the puzzle. On the other hand, explanations based on investors’ lottery preferences and market frictions show some promise in explaining the puzzle. Together, all existing explanations account for 29–54% of the puzzle in individual stocks and 78–84% of the puzzle in idiosyncratic volatility-sorted portfolios. Our methodology can be applied to evaluate competing explanations for other asset pricing anomalies.