Do Investors Expect Higher Returns from Safer Stocks than from Riskier Stocks?

Abstract

The relationship between risk and return lies at the heart of modern finance. This relationship is embodied within such core concepts as the capital market line and the security market line. Both of these graphs feature a positive slope, meaning that the higher the risk the higher the expected return. I propose that even though investors may state that in principle, risk and expected return are positively related, in practice they form judgments in which the two are negatively related.

I have organized my remarks around the following six questions: (1) What evidence is there that investors judge risk and return to be negatively related? (2) What psychological forces would lead investors to form such judgments about risk and return? (3) What implications do such judgments hold for the broad debate between proponents of market efficiency and proponents of behavioral finance? (4) How robust are judgments about risk and return to judgments about the expected equity premium? (5) To what extent are investors consciously aware of the manner in which they form judgments about risk and return? (6) How reliable is the evidence on risk and return presented here?