Prospect Theory and the Risk-Return Trade-off
Huijun Wang, University of Delaware
Jinghua Yan, SAC Capital
Jianfeng Yu, University of Minnesota

This paper studies the cross-sectional risk-return trade-off in the stock market. Although a positive relation between risk and expected return is generally expected, recent empirical evidence suggests that low-risk firms tend to earn higher average returns. The authors apply prospect theory to shed light on this apparent violation of a fundamental principle in Finance. Prospect theory posits that when facing prior loss relative to a reference point, individuals tend to be risk seeking rather than risk averse. Consequently, among stocks where investors face prior losses, a negative risk-return relation should exist. By contrast, among stocks where investors face capital gains, the traditional positive risk-return relation should emerge, since investors of these stocks are risk averse. Using several intuitive measures of risk, empirical support for these hypotheses is provided.

The relation of risk to return is of fundamental importance in investments. Using behavioral methods, this study explains why low-risk firms tend to earn higher returns than high risk firms. The results should interest investment managers who can condition their holdings based on predictions of investor behavior.