Disagreement and the risk-return relation

- We construct disagreement of crowded trades (DCT) index to measure disagreement.
- We find the time-varying effect of DCT change on the risk-return relation.
- Risk-return relation is negative (positive) when DCT change is negative (positive).
- Our results have important practical implications for asset allocation decisions.
- Future work can study the impact of individual stock DCT on the risk-return relation.

Disagreement is an important behavioral factor in financial market, and this paper investigates the impact of disagreement on the risk-return relation. We construct disagreement of crowded trades (DCT) index to measure disagreement, and discover that DCT has a significant impact on the risk-return relation. Furthermore, DCT change has a time-varying effect on the risk-return relation. When DCT change is negative, the risk-return relation is significant and negative; when DCT change is positive, the risk-return relation is significantly positive. When we use different conditional variance models and different market portfolios, such results are still robust. Moreover, our empirical results have important practical implications for asset allocation decisions.