Reference-Dependent Preferences and the Risk-Return Trade-Off
University of Delaware
SAC Capital Advisors; University of Pennsylvania - Wharton Financial Institutions Center
University of Minnesota
This paper studies the cross-sectional risk-return trade-off in the stock market. A fundamental principle in finance is the positive relation between risk and expected return, whereas recent empirical evidence suggests the opposite. We apply reference-dependent preferences to shed light on this violation. Reference-dependent preferences (e.g., prospect theory) typically posit that when facing prior losses, individuals tend to be risk seeking rather than risk averse. Consequently, among stocks where average investors face prior losses, there could be a negative risk-return relation. By contrast, among stocks where average investors face capital gains and are risk averse, the traditional positive relation should emerge. Using several intuitive risk measures, we provide consistent support for our hypotheses.
Number of Pages in PDF File: 55
Keywords: Prospect Theory, Risk-Return Trade-Off, Mental Accounting, Beta, Risk, Uncertainty
JEL Classification: G02, G12, G14
Date posted: May 30, 2012 ; Last revised: October 8, 2014
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