The Relationship Of Risk-return Based On Reference-dependence Preference

The trade-off of risk and return is not only the focus of academic research,but also the concern of the investment community.Since the advent of CAPM,both the academia and the industry have firmly believed that the trade-off of risk and return is positive.However,the Bowman paradox has caused many scholars to question the CAPM,which has led to a series of tests on CAPM.“Investors are economic man” is one of the prerequisites of CAPM.Nevertheless,plenty of Chinese investors are not economic man.Because the majority of them are individual investors who lack professional knowledge,which leads to significant herding effects,and individual investors do not become rich by investing.Prospect theory points out that individuals do not care about absolute returns but relative returns,and the evaluation criteria of everything is based on a reference point.To this end,by analyzing the psychological profit of the investors in China,this article found that for the Chinese stock market investors,making profits from the stock market is a low probability event.Cumulative prospect theory holds that individuals tend to overestimate low probability events,which may influence investors' investment decisions and change the relationship between risk and return.Hence,the paper studies the trade-off of risk-return based on the reference-dependent preferences according to the cumulative prospect theory.This paper selects a sample of 2447 Chinese companies during 1994-2016 on Shanghai and Shenzhen Stock Exchange.The paper draws the main conclusions by using a series of Fama-MacBeth cross-sectional regressions: the risk-return relationship is negative if investors made a large profit in last period,but the risk-return relationship is positive if investors made a large loss in last period.The paper uses cumulative prospect theory to explain the conclusion.Except that,the paper comes to other conclusions.First,the relationship between risk and return depends on the reference point.Second,the relationship between risk and return is not stable around the reference point,that is,the risk attitude of the investor is unstable when the loss or profit in the previous period is relatively small.Third,the last closing price performs better than the turnover-based weighted average price in the past 260 week as a reference price,that is,the former is closer the investors' inner reference price.The conclusion of this paper shows that the relationship between risk and return in Chinese stock market is different from CAPM and American stock market,which shows that the investors in Chinese stock market are still irrational.The study based on the referencedependent preference not only enriches the academic community's discussion of this issue,but also sounds the alarm for investors.We hope to attract the attention of the government and investors,and hope the China's stock market develops healthily and quickly.