Chapter 6 – Perceptions about Risk and Return
Chapter Six
Perceptions about Risk and Return
OVERVIEW
Chapter 6 describes how corporate managers perceive the relationship between
risk and return.
Managers appear to associate higher expected returns to growth stocks than to
value stocks, a pattern that is at odds with the finding that value stocks have
outperformed growth stocks historically.
In forming estimates of the market risk premium, managers exhibit the hot hand
fallacy, whereby they expect high returns to follow high returns and low returns to follow
LEARNING OBJECTIVES
The main objective of this chapter is for students to demonstrate that they can identify the
manner in which managers, investors and analysts perceive the relationship between risk
and return. After completing this chapter students will be able to:
Chapter 6 – Perceptions about Risk and Return
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positive relationship between risk and return is reflected by the fact that expected return
is negatively related to firm size and positively related to book-to-market equity.
Risk and Return: Psychology for Estimating the Market Risk Premium
Section 6.2 discusses the die rolling experiment. This experiment sets the stage for the
Financial Executives and the Market Risk Premium
In respect to risk and return at the level of the market, financial executives appear
to judge risk and return as being negatively related. Yet at horizons of one year and
Investor Biases in Estimating the Market Risk Premium
Individual investors’ forecasts of market returns feature continuation more
frequently than is warranted. The bias associated with unwarranted predictions of
continuation is the hot hand fallacy (or extrapolation bias). Professional investors’
Chapter 6 – Perceptions about Risk and Return
Executives, Insider Trading, and Gambler’s Fallacy
When engaged in insider trading, managers buy and sell the stocks of their firms
as if their forecasts exhibit gambler’s fallacy. They sell stocks whose prices have recently
Survey Evidence on Project Discount Rates
When computing NPV in practice for the purpose of capital budgeting, managers
do not appear to vary the discount rate to reflect the degree of project risk. Instead they
TEACHING TIPS FOR POWERPOINT SLIDES
Before showing the first PowerPoint slide, instructors might ask students to keep
in mind that traditional textbooks in corporate finance emphasize that risk and return are
Chapter 6 – Perceptions about Risk and Return
Slide 5
Slide 5 points out that in respect to up and down years, the S&P 500 behaves
Slide 17-18
Slides 17-18 points out that corporate managers expect higher returns from
growth stocks than from value stocks.
Slide 17 makes the point that the expected returns of security analysts exhibit
Instructors might ask students whether some other psychological trait might
explain why executives sell the stocks of their firms after the prices of those stocks have
recently increased, but hold or purchase those stocks if their prices have recently
declined. The point here is that loss aversion might also explain the behavior. Executives
Chapter 6 – Perceptions about Risk and Return
Slide 21
Slide 21 pertains to the use of the heuristic “one discount rate fits all projects.”
Managers tend to use the same discount rate when computing project NPV, regardless of
Slide 26
Slide 26 describes corporate nudges. Managers can mitigate the biases associated