Disagreement, speculation, and the idiosyncratic volatility

We propose that speculative trading plays an important role in explaining the idiosyncratic volatility (IVOL) puzzle and its associated empirical patterns in the joint presence of investor disagreement and short-sale constraints. Our analysis shows that: (i) the return spread between high and low IVOL quintile portfolios is closely related to both aggregate and firm-level disagreement, (ii) the common IVOL (CIV) factor is directly correlated with aggregate disagreement, and (iii) such correlation between the IVOL puzzle and disagreement presents mainly among stocks that are more likely short-sale constrained. Overall, we provide a unified mechanism that high aggregate disagreement leads to more firm-level speculative trading, which is consistent with a factor structure in IVOL and positive correlations between stock beta, the IVOL puzzle, and trading volume.