The Effect of Relative Wealth Concerns on the Cross-section of Stock Returns∗

We test the cross section implications of an asset pricing model where agents have relative wealth concerns with respect to a reference group which we call their peers. The literature suggests two reasons (not mutually exclusive) why investors might want to hedge local risk resulting from relative wealth concerns: keeping up with the Joneses preferences and competition for local assets in short supply. In the presence of some market friction, a negative risk premium obtains for the local risk factor -non-diversifiable wealth of the peersin equilibrium. We study the empirical implications of this model using as peer groups the nine US Census divisions. As a proxy for the local risk factor we use divisional labor income. We find substantial support for the predictions of the model; moreover the effects are stronger in divisions with lower population density. A possible explanation is that the effect of relative wealth concerns is stronger in low density regions because it is easier to identify the wealth of the reference group. Additionally, lower density may imply higher competition for assets in short supply (like human capital) and, therefore, a stronger desire to hedge the corresponding inflationary risk. JEL Codes: G15, G12, G11.