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Reference-Dependent Preferences and the Risk-Return Trade-Off

56 Pages Posted: 30 May 2012 Last revised: 17 Jun 2016

Huijun Wang

University of Delaware

Jinghua Yan

SAC Capital Advisors; University of Pennsylvania - Wharton Financial Institutions Center

Jianfeng Yu

Tsinghua University - PBC School of Finance

Date Written: June 16, 2016

Abstract

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

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

Huijun Wang

University of Delaware ( email )

B & E Finance, UD
306 Purnell Hall
NEWARK, DE Delaware 19716
United States

Jinghua Yan

SAC Capital Advisors ( email )

330 Madison Avenue, 35th Floor
New York, NY 10017
United States

University of Pennsylvania - Wharton Financial Institutions Center ( email )

2306 Steinberg Hall-Dietrich Hall
3620 Locust Walk
Philadelphia, PA 19104
United States

Jianfeng Yu (Contact Author)

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

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