The Value of Investor Sophistication

We propose idiosyncratic volatility based return spread as a new measure of the stock-level value of investor sophistication. We find that stocks with a high value of investor sophistication tend to have low average returns, and this effect is pronounced for highly short-sale constrained stocks. The negative relation between expected stock returns and the value of investor sophistication is not explained by variables that affect the relation between idiosyncratic volatility and returns. Our results are robust with respect to whether idiosyncratic volatility is estimated using different factor models or methods. Such relation is more prominent in periods of high investor sentiment, high market uncertainty, and economic contraction.