Tuesday, 15 January 2013

Book Review: The Missing Risk Premium by Eric Falkenstein

Not many books can be summed up in one sentence but this one can be and author Falkenstein does it himself in this quote taken from his Falkenblog: "... risk is generally not related to expected return because people are more envious than greedy". This is a radical blockbuster statement with significant implications for both finance theorists and practically minded investors.

The book is a meticulous exposition and expansion of this quote - starting with a description of standard finance theory relating to portfolio management and asset pricing focusing on risk vs return, the "how things are supposed to work" according to the theory, which is basically that there is a expected return premium for taking on risk based on one and only one starting assumption "... that our happiness is solely dependent on our individual wealth and increases at a decreasing rate" i.e. people are greedy. Falkenstein proceeds to document the extensive finance research that shows how the theory simply does not work in the real world - empirically vacuous or bankrupt, as he puts it - and how the attempts to fix it have created a hodge-podge of adjustments devoid of intuitive sense. The basic idea that there should be a higher expected return for taking on more risk he says has been perversely twisted by defenders of the Capital Asset Pricing Model faith - anything that shows a higher actual return, like small cap stocks and value stocks, must be riskier, though no one can actually say how these types of assets are riskier.

In fact (the factual-ness of which he takes many pages to demonstrate - there are lots of footnotes to studies done by many researchers) - Falkenstein finds that the highest risk (in an intuitive sense) end of many asset classes displays markedly lower, not higher, returns. Examples in penny stocks, equity options, IPOs, currencies, corporate bonds, futures, real estate are cited. This is the empirical part of the explanation of why low volatility investing works - it eliminates the significant chronic return drag at the highest risk end of the spectrum.

Falkenstein then moves on to his theory, the "because" part of the quote at the top of this review. He proposes that instead of the standard utility function of absolute ever-increasing happiness with wealth that underpins present finance theory, we should instead use a relative utility function to understand asset pricing. Adopting relative utility means that it is assumed people primarily behave in a greedy fashion, in other words that they are happy or satisfied if they are doing well in reference to others. In investment terms, people use benchmarks to judge success. They want to outperform relative to some standard such as the TSX Composite. Under such an assumption, Falkenstein shows, with the same straightforward math as for the CAPM, that the risk premium is zero. A zero risk investment is no longer something like a no-volatility T-bill but a security that tracks the benchmark. He says this viewpoint explains asset pricing and indeed many other human behaviours (such as why 21st century humans are not happier than people of a century ago despite being a lot richer in absolute terms).

Falkenstein goes on to examine how and why people take too much financial risk and why he thinks his theory has been ignored for so long (his own PhD dissertation was on the subject in 1994 and he traces key ideas to others going back to the 1970s). The final chapter outlines how to benefit in a practical way from his findings and theory. That is the low volatility strategy. The proof is in the pudding he says and he cites studies and his own out-of-sample investing success as evidence.

This book is important to every investor. If he's right, it points to a better investing strategy through minimum variance or low beta portfolios. There are low volatility/ low beta ETFs available to ordinary investors. Falkenstein's theory implies that passive index ETF investing will do poorly (lower returns and higher volatility) in comparison to low volatility ETF investing (assuming, of course, that fees remain within certain limits). Unlike passing anomalies that have disappeared or for which there is no theory to support why outperformance should continue (we note the irony of referring to outperformance as a test of whether it's good or not but that's the way the world works!), this book offers such support. If he's right, the ideas of this book will be viewed as foundational to finance.

Even if you think he's wrong, the book will surely make you think hard. If you think you understand the what and why of finance theory, try to say why's he's wrong.

Much of it is not easy to read, as he slides into and out of highly technical statistical or economic issues. On the other hand, much of it is also highly intuitive and appeals to common sense using plain language.

Falkenstein is very aware of his rebel status in finance. "A crank is simply someone with a minority opinion among his peers, and the key to whether that person is considered a genius or stupid is whether he was correct, which is often known only with hindsight." Those who would dismiss him merely because he thinks the CAPM is fatally broken, in opposition to the mainstream of finance academics, are doing so too blithely. He is extremly conversant with the finance literature (208 footnotes in this brief book and reams of citations in his bibliography) and it sure looks like he understands the stats and math (here, I must express my own limitation in being able to judge this properly). Read his blog and his home page here to judge for yourself whether he knows what he's talking about. These sites contain links to many of his papers where much of the book's ideas are also found. There's even a hilareous video with toy people called Asset Pricing Theory Explained and a 5 minute summary of this book on this page.

Falkenstein writes like a man in a hurry. Though generally very eloquent and quotable, sometimes his sentences are dense and must be re-read to detect implicit commas and awkward phrasing, sometimes words even seem to be missing or he assumes the reader knows technical stuff as well as he does. There's also no index - that would help for the paper version (search works fine in the Kindle on a laptop). These are quibbles.

Is he right? Time will certainly tell - about 2050 is the date he says the data will have gone on long enough for the doubters to conclude with statistical tests that he is right. Meantime, we can check his blog for evidence coming in as he reviews new articles on the topic, such as this post last May. The discussion of some EDHEC findings in that post and many accounts within the book of findings in finance research subsequently being negated when data errors and sampling problems, certainly induce caution in reaching a conclusion.

Nevertheless, the arguments and evidence is credible and convincing enough that, as a matter of disclosure, I will say that I have bought a significant position in a low volatility equity ETF.

  • "The idea that to get rich you need to take risk seems to imply that risk begets higher returns, but this is just a logical fallacy, like using successful gamblers as role models for investing."
  • "Although broad asset indexes contain the wisdom of crowds, they also necessarily contain a lot of foolishness that make them distinctly suboptimal portfolios. ... By ridding your asset classes of these objectively bad assets, you can improve your returns rather simply, and this has been demonstrated in real time via the dominance of low-volatility investing."
  • "...like the latest miracle diet, the latest anomaly is treated skeptically by your average expert for good reason—because most have been dead ends based on selection biases or bad data."
  • "when you measure distress directly, as opposed to merely inferring it from the size and value dimensions, such stocks deliver abnormally low returns, patently inconsistent with value and size effects as compensation for the risk of financial distress."
  • "R-rated movies are the high volatility stocks of the movie industry."
  • "Simon Lack notes that over the 1998-2010 period, a whopping 97% of the dollar profits generated by the hedge fund industry went to the fund managers, not the investors."
  • "Risk takers dominate our lives via their disproportionate effect on our genes and their influence on our technology and culture. They did not become successful, however, merely by taking some abstract risk that is the same for everyone and then enjoy the higher rewards that came with it. They instead took the right risks, those consistent with their unique strengths, and reaped rewards consistent with a mastery of something important."
  • "... children not only lie, but lie more the higher their IQ."
  • "A major problem is that as most of the active and esteemed researchers have built their careers extending or modifying the current framework, it would be very costly to classify work built on bad assumptions as irrelevant, and so there is this strong desire to work within the paradigm and salvage all those mentor’s reputations."

Rating: 5 out of 5 stars, original and important, a must read

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