Time‐varying risk preference and equity risk premium forecasting: The role of the disposition effect

This study examines whether the disposition effect can explain time‐varying risk preference and predict the equity risk premium. To do so, we propose an augmented general autoregressive conditional heteroskedasticity (GARCH)‐in‐Mean model unraveling the complex relationship between unrealized gains/losses, realized returns, and the equity risk premium. In our model, the risk aversion coefficient varies with the market state of unrealized gains/losses. Using data from the US stock markets, we show strong evidence that the disposition effect drives time‐varying risk preference: The risk aversion coefficient is significantly positive during periods of unrealized gains, but insignificant during periods of unrealized losses. These findings reconcile the conflicting results of the risk‐return trade‐off in existing literature. Moreover, our model shows significant predictability of the equity risk premium, both in‐sample and out‐of‐sample. Incorporating our model's predictions can yield substantial utility gains for a mean‐variance investor. Our results indicate that the disposition effect leads to time‐varying risk preference and thus induces equity risk premium predictability.