Understanding the Risk-Return Relation: The Aggregate Wealth Proxy Actually Matters

78 Pages Posted: 19 Nov 2014 Last revised: 5 Dec 2017

See all articles by Scott Cederburg

Scott Cederburg

University of Arizona - Department of Finance

Michael S. O'Doherty

University of Missouri at Columbia - Department of Finance

Date Written: August 18, 2017

Abstract

The ICAPM implies that the market's conditional expected return is proportional to its conditional variance and that the reward-to-risk ratio equals the representative investor's coefficient of relative risk aversion. Prior studies examine this relation using the stock market to proxy for aggregate wealth and find mixed results. We show, however, that stock-based tests suffer from low power and lead to biased estimates of the risk-return tradeoff when stocks are an imperfect market proxy. Tests designed to mitigate this bias by incorporating a more comprehensive measure of aggregate wealth produce large, positive estimates of the risk-aversion coefficient around seven to nine.

Keywords: Aggregate wealth portfolio, ICAPM, Risk-return tradeoff

JEL Classification: G10, G12, G17

Suggested Citation

Cederburg, Scott and O'Doherty, Michael S., Understanding the Risk-Return Relation: The Aggregate Wealth Proxy Actually Matters (August 18, 2017). Cederburg, Scott, and Michael S. O'Doherty, 2017, Understanding the risk-return relation: The aggregate wealth proxy actually matters, Journal of Business and Economic Statistics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2526548 or http://dx.doi.org/10.2139/ssrn.2526548

Scott Cederburg (Contact Author)

University of Arizona - Department of Finance ( email )

McClelland Hall
P.O. Box 210108
Tucson, AZ 85721-0108
United States

Michael S. O'Doherty

University of Missouri at Columbia - Department of Finance ( email )

Robert J. Trulaske, Sr. College of Business
401 Cornell Hall
Columbia, MO 65211
United States

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