Research Articles

Idiosyncratic Risk, Long-Term Reversal, and Momentum

R. David McLeana1

a1 University of Alberta, School of Business, 4-20K Business Bldg., Edmonton, Alberta T6G 2R6, Canada.


This paper tests whether the persistence of the momentum and reversal effects is the result of idiosyncratic risk limiting arbitrage. Idiosyncratic risk deters arbitrage, regardless of the arbitrageur’s diversification. Reversal is prevalent only in high idiosyncratic risk stocks, suggesting that idiosyncratic risk limits arbitrage in reversal mispricing. This finding is robust to controls for transaction costs, informed trading, and systematic relations between idiosyncratic risk and subsequent returns. Momentum is not related to idiosyncratic risk. Momentum generates a smaller aggregate return than reversal, so the findings along with those in related studies suggest that transaction costs are sufficient to prevent arbitrageurs from eliminating momentum mispricing.


I am especially grateful to Hendrik Bessembinder (the editor), Wayne Ferson, Jeffrey Pontiff, and Michael Schill (the referee) for many valuable suggestions. I also thank Alon Brav, David Chapman, Tarun Chordia, Karl Diether, Richard Evans, Cliff Holderness, Gang Hu, Mark Huson, Randall Morck, Samuel Tibbs, and Mengxin Zhao; seminar participants at Boston College, University of Alberta, University of Virginia (Darden), University of Miami, Southern Methodist University, SUNY Buffalo, University of Cincinnati, and George Mason University; and conference participants at the Inquire-Europe Symposium on Portfolio Choice, the 2005 Financial Management Association International (FMA) Doctoral Consortium, and the 2005 FMA Special PhD Student Sessions for helpful comments. I acknowledge financial support from the Southam/Edmonton Journal Fellowship Award.