Prospect Theory and the Risk-Return Tradeoff

Abstract:     
This paper studies the cross-sectional risk-return tradeoff in the stock market. The fundamental principle in finance posits a positive relation between risk and expected return, whereas recent empirical evidence suggests that low-risk firms tend to earn higher average returns. We apply prospect theory to shed light on this violation of the fundamental principle in finance. Prospect theory posits that when facing prior loss relative to a reference point, individuals tend to be risk-seeking, rather than risk-averse. In other words, when current stock prices are lower than their reference prices, average investors of these stocks tend to be risk-seeking. Consequently, among these stocks, there should be a negative risk-return relation. By contrast, among the stocks where most investors face capital gains, the traditional positive risk-return relation should emerge since average investors of these stocks are risk averse. Using several intuitive risk measures for layman investors, we provide strong empirical support for our hypotheses. The role of prospect theory in the idiosyncratic volatility puzzle is also discussed.

Number of Pages in PDF File: 47

working papers series