Why Risk and Return are Uncorrelated: A Relative Status Approach
Eric G. Falkenstein
Pine River Capital Management
October 7, 2006
This paper presents a utility function refinement that explains the empirical irrelevance of risk to returns. The key is that in an environment where people care about relative wealth, risk is a deviation from what everyone else is doing, and therefore becomes like diversifiable risk in the CAPM, avoidable. Using an equilibrium or an arbitrage argument, a relative status oriented utility function creates a zero risk-return correlation via a market model that implies a zero risk premium. This approach is described as being theoretically consistent, intuitive and a better description of the data.
Number of Pages in PDF File: 38
Keywords: status, relative risk, CAPM, equity risk premium, cross-sectional asset pricing
JEL Classification: D01, D81, G11, G12
Date posted: October 12, 2006 ; Last revised: December 12, 2014
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