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 the value premium varies with investors’ propensity to speculate, and therefore includes a substantial behavioral component. 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.