Beta, Value, and Growth: Do Dichotomous Risk-Preferences Explain Stock Returns?

Abstract

I propose a Capital Asset Pricing Model in which investor demand exhibits a speculative component. In equilibrium, investors' optimal trade-off between diversification and speculation generates predictable patterns for stocks with extreme book-to-market ratios. Using data on U.S. stocks, I find evidence consistent with the model predictions. I show that simple trading strategies on extreme book-to-market stocks yield positive and robust abnormal returns, mostly driven by the underpricing of value stocks. The results are stronger when naive investor demand is large, and during economic downturns. Overall, the findings shed new light on the role of dichotomous risk-preferences in asset pricing.

Keywords: Value premium; Speculative demand; Beta; Business cycle.

JEL Classification: G11, G12, G14, G41.