The Relationship between Risk and Return Based on the Prospect Theory: Case Study of Selected Companies in Tehran Stock Exchange

Abstract

In most studies, examining the relationship between risk and return, based on the theory of expected utility, an investor has always been considered as a risk-averse person. While the prospect theory considers both risk aversion and investor risk-taking based on existing realities. The innovation of this paper is to consider the separation of risk-taking behavior from rational one of investors (risk aversion). In this paper, the relationship between risk and return based on the prospect theory for companies of four selected industries during 2001-2020 by panel data and panel quantile regression method has been investigated. Investors' behavior in the prospect theory is sensitive to the reference point. In this paper, the average return on industry assets is considered as a reference point. Hence, the selected companies were divided into two groups of companies with asset returns (ROA) above and below the industry average. The result showed that the investor's behavioral model changed relative to the reference point. Investors are risky below the reference point, contrary to traditional theories of utility. Of course, at returns above the reference point, investors will still be risk-averse. Comparing the results of estimation of two methods (panel data and panel quantile) shows that this situation is also true in different risk quantiles. So that, the sign of the relationship between risk and return at the high and low levels of the reference point is compatible with the theoretical foundations. Therefore, the behavior of investors in selected companies follows the prospect theory.