| Summary: | We document that stocks that experience sudden increases in idiosyncratic volatility underperform otherwise similar stocks in the future, and we propose that this phenomenon can be explained by the Miller conjecture [Miller E (1977) Risk, uncertainty, and divergence of opinion. J. Finance 32(4):1151-1168]. We show that volatility shocks can be traced to unusual firm-level news flow, which temporarily increases the level of investor disagreement about the firm value. At the same time, volatility shocks pose a barrier to short selling, preventing pessimistic investors from expressing their views. In the presence of divergent opinions and short-selling constraints, prices initially reflect optimistic views but adjust downward in the future as investors' opinions converge. © 2017 INFORMS.
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