Why Risk and Return are Uncorrelated: A Relative Status Approach

Abstract

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.

Keywords: status, relative risk, CAPM, equity risk premium, cross-sectional asset pricing

JEL Classification: D01, D81, G11, G12