Demanding More and Expecting Less: The Gap Between Required and Expected Returns
Dr. Cary Frydman
Associate Professor of Finance and Business Economics
Marshall School of Business
University of Southern California
Many surveys have found that respondents report expectations of future stock returns that are extrapolative. These expectations are inconsistent with required returns predicted by prominent asset pricing models. However, such tests implicitly use survey-based expectations as an estimate for model-based required returns. We investigate the relationship between expected and required returns in a pre-registered experiment. Experimental subjects are incentivized to report a time series of expected returns, required returns, and perceptions of disaster risk. We find that elicited required returns and expected returns are strongly negatively correlated over time: subjects demand more compensation for risk precisely when they expect less compensation. We also observe that subjects require higher returns when they perceive disaster risk to be higher, in line with the predictions of rare disaster models. Our results suggest that researchers should also analyze required returns – instead of only expected returns – when using survey data to test theories of portfolio choice and asset pricing. We speculate that overestimation of low probability disasters drives the negative correlation between expected and required returns.
