We test whether the low-risk effect is driven by (a) leverage constraints and thus risk should be measured using beta vs. (b) behavioral effects and thus risk should be measured by idiosyncratic risk. Beta depends on volatility and correlation, where only volatility is related to idiosyncratic...

The authors show that leverage aversion changes the predictions of modern portfolio theory: Safer assets must offer higher risk-adjusted returns than riskier assets. Consuming the high risk-adjusted returns of safer assets requires leverage, creating an opportunity for investors with the ability...