Prospect Theory 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. This tenet 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 a 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. Consequently, among stocks where investors face prior losses, there could be a negative risk-return relation. By contrast, among stocks where investors face capital gains, the traditional positive risk-return relation should emerge, since investors of these stocks are risk averse. Using several intuitive measures of risk, we provide consistent empirical support for our hypotheses.
Number of Pages in PDF File: 53
Keywords: Prospect Theory, Risk-Return Trade-Off, Mental Accounting, Beta, Risk, Uncertainty
JEL Classification: G02, G12, G14working papers series
Date posted: May 30, 2012 ; Last revised: January 18, 2014
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