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
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: Suggested Citation