Risk defined in a context of status seeking and signaling rather than volatility or beta

Envy will get you every time.  Here is a paper by Erik Falkenstein on risk and return in a relative risk utility context where risk premia in status equilibria are more or less zero (not sure I have that right) and returns are earned for deviations from the status quo.  I don't have the chops to critique this but have enough experience of independent schools to know the destructive power of status seeking and signaling.  Maybe he's right. Who knows?

Risk and Return in General: Theory and Evidence

Eric G. Falkenstein

Pine River Capital Management

Date Written: June 15, 2009

Abstract:

Empirically, standard, intuitive measures of risk like volatility and beta do not generate a positive correlation with average returns in most asset classes. It is possible that risk, however defined, is not positively related to return as an equilibrium in asset markets. This paper presents a survey of data across 20 different asset classes, and presents a model highlighting the assumptions consistent with no risk premium. The key is that when agents are concerned about relative wealth, risk taking is then deviating from the consensus or market portfolio. In this environment, all risk becomes like idiosyncratic risk in the standard model, avoidable so unpriced.

Random Excerpts: 

• Risk, meanwhile, has devolved into the financial equivalence of dark matter, evident solely by its effects.  

• I present a model that explains the null risk-return result as an equilibrium when people internalize risky decisions by comparing themselves to others, as opposed to the standard approach to risk based on the absolute volatility of their wealth. If utility is a status function, specifically the value of wealth relative to one’s peers, only deviations from the consensus are ‘risky’ (i.e., benchmark risk, see Cremers and Petajisto, 2006). ‘Risk’ can be avoided in this context by everyone holding an identical market portfolio, making it similar to diversifiable risk in a world of absolute returns, avoidable, and so unpriced. Investors see too little exposure to an asset class is just as bad as too much; one is cowardly and the other reckless, objectively measured by how far these bets take one from the average. 

• It seems reasonable to presume that for these investment professionals and academics, risk, intuitively, is a return relative to a benchmark. If all investors act ‘as if‘ they are benchmarking to aggregate indices, risk will not be priced in equilibrium.  

• A relative-status oriented utility function generates a factor model consistent with the familiar CAPM and APT models, except the risk premiums are zero. Beta is still descriptive of relative volatility, and generates normative predictions for volatility minimization.  ... The portfolio optimization algorithm for an investor with typical preferences is trivial and mimics practice: allocate assets to the standard categories of conventional wisdom, because this minimizes relative wealth volatility and maximizes returns. The idea that nondiversifiable risk is not priced because it is unnecessary is augmented, so that diversifiable risk is also not priced because it too is unnecessary in the sense of avoiding deviations from the average portfolio. As the saying goes, one has to take risk to generate high returns, but there is no greater expected return merely for taking risk of any sort.