56 Pages Posted: 30 May 2012 Last revised: 17 Jun 2016
Date Written: June 16, 2016
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.
Keywords: Prospect theory, Risk-return trade-off, Risk, Uncertainty, Capital gains overhang
JEL Classification: G02, G12, G14
Suggested Citation: Suggested Citation
Wang, Huijun and Yan, Jinghua and Yu, Jianfeng, Reference-Dependent Preferences and the Risk-Return Trade-Off (June 16, 2016). Available at SSRN: https://ssrn.com/abstract=2070910 or http://dx.doi.org/10.2139/ssrn.2070910