Untangling The Idiosyncratic Volatility Puzzle: Perspectives From The Sri Lankan Market
Dr. Dilani Ranasinghe
Department of Economics, University of Peradeniya, Sri Lanka
Dr. Roshan Fernando
Department of Economics, University of Peradeniya, Sri Lanka
Abstract
The Capital Asset Pricing Model (CAPM) has been a cornerstone in asset pricing literature, assuming that investors hold well-diversified portfolios, making idiosyncratic volatility irrelevant for pricing stock returns. However, Merton (1987) contends that information asymmetries prevent investors from achieving full diversification, making idiosyncratic volatility a critical factor in asset pricing. Supporting this argument, Goetzmann and Kumar (2008) provide empirical evidence that a significant portion of investor portfolios in the United States consists of undiversified holdings.
This study reevaluates the traditional view by examining the role of idiosyncratic volatility in asset pricing, challenging the CAPM's assumption of perfect diversification. By considering the prevalence of undiversified portfolios, it explores how idiosyncratic volatility may indeed impact stock returns, shedding light on its relevance as a pricing factor. Through empirical analysis and theoretical insights, this research contributes to the ongoing discourse on asset pricing models and their applicability in real-world investment scenarios