Why Risk and Return are Uncorrelated: A Relative Status Approach

38 Pages Posted: 12 Oct 2006 Last revised: 12 Dec 2014

Date Written: October 7, 2006

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

Suggested Citation

Falkenstein, Eric G., Why Risk and Return are Uncorrelated: A Relative Status Approach (October 7, 2006). Available at SSRN: https://ssrn.com/abstract=936744 or http://dx.doi.org/10.2139/ssrn.936744

Eric G. Falkenstein (Contact Author)

Pine River Capital Management ( email )

601 Calson Parkway, Suite 330
Minnetonka, MN 55347
United States
6123091588 (Phone)
6123091588 (Fax)

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