Are investors/traders motivated primarily by absolute wealth or relative wealth? Is outperforming peers a strong motivation? In the February 2007 draft of his paper entitled “Why Risk is Not Related to Return”, Eric Falkenstein examines evidence for and implications of relative wealth as the principal motivator of investors. Using a wide range of examples, he argues that:
- Directly measured risk seldom relates positively to average returns. In fact, there is no measure of risk that produces a consistently linear scatter plot with returns across a variety of investments (stocks, banks,
stock options, yield spread, corporate bonds, mutual funds, commodities, small businesses, movies, lottery tickets and bets on horse races). - Humans are social animals, and processing of social information (status within group) is built into our brains. People care only about relative wealth.
- Risk is a deviation from what everyone else is doing (the market portfolio) and is therefore avoidable and unpriced. There is no risk premium.
- The poor returns to idiosyncratic risk derive from the tendency of overconfident investors to select investments with high idiosyncratic volatility as the (delusional) path to highest returns.
- Since risk (deviation from the norm) is by definition inversely related to popularity, asset prices may exhibit momentum or bubbles over intermediate horizons based on expectations rather than profits.
- The benchmark for an investor depends on peer group, consistent with home bias in portfolio holdings.
In summary, status may be more powerful than wealth as a motivator, with significant implications for investor/trader behavior.
