Extrapolation and Risk-Return Trade-offs

Abstract

This study investigates the impact of return extrapolation on risk-return trade-offs in both the aggregate time series and the cross section. We find that the relation between the market's expected return and expected variance is positive during periods with a low degree of extrapolative weighting (DOX), as proposed by Cassella and Gulen (2018), but turns negative during high-DOX periods. In the cross section, we find that low-risk anomalies are significantly more pronounced following high-DOX periods and among firms with high firm-level DOX. These findings indicate that extrapolation leads to mispricing, thereby undermining the traditional risk-return trade-off.

Keywords: JEL Classification: G11, G12, G40 Behavioral finance, Extrapolation, Risk-return trade-off, Sentiment

JEL Classification: G11, G12, G40