IDIOSYNCRATIC RISK AND WHEN TO TILT TOWARD VALUE

While the outperformance of value relative to growth portfolios has been well established, there is still debate over whether this outperformance is the result of a systematic risk factor or a behavioral tendency. The distinction is crucial to determining the expected returns of value- and growth-tilted portfolios. We find that when idiosyncratic volatility-the key arbitrage portfolio holding cost-increases, the outperformance of value correspondingly increases. Conversely, when idiosyncratic volatility is low, the outperformance is reduced. This is consistent with a behavioral explanation and has important ramifications for the timing of value tilts employed by a portfolio manager.