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Safety First, Loss Probability, and the Cross Section of Expected Stock Returns

Author

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  • Ji Cao
  • Marc Oliver Rieger
  • Lei Zhao

Abstract

Recent studies show that loss probability (LP) is a decisive factor when peopleevaluate risk of assets in laboratory experiments, suggesting a positive relationshipbetween LP and expected stock returns. This corresponds to the classical “Safety-First” principle. We find strong empirical support for this prediction in the U.S.stock market. During our sample period, average risk-adjusted return differencesbetween stocks in the two extreme LP deciles exceed 0.75% per month. The posi-tive LP effect, characterized by the intention of some investors to pay low prices forhigh LP stocks, remains significant after controlling for traditional downside riskmeasures.

Suggested Citation

  • Ji Cao & Marc Oliver Rieger & Lei Zhao, 2019. "Safety First, Loss Probability, and the Cross Section of Expected Stock Returns," Working Paper Series 2019-02, University of Trier, Research Group Quantitative Finance and Risk Analysis.
    • Handle: RePEc:trr:qfrawp:201902
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    More about this item

    Keywords

    Loss Probability; Stock Returns; Mental Accounting; Safety-First; RiskAttitudes;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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