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
November 25, 2015
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. Using several intuitive risk measures, we show that the negative risk-return relation is much more pronounced among firms in which investors face prior losses, but the risk-return relation is positive among firms in which investors face prior gains. We consider a number of possible explanations for this new empirical finding, and conclude that reference-dependent preference is the most promising explanation.
Number of Pages in PDF File: 57
Keywords: Prospect theory, Risk-return trade-off, Risk, Uncertainty, Capital gains overhang
JEL Classification: G02, G12, G14
Date posted: May 30, 2012 ; Last revised: November 27, 2015
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