'The Missing Risk Premium': A Book That Will Change the Way You Think About Trading
Eric G. Falkenstein argues that there is no risk premium and there never was, so conventional investing advice is deeply misguided.
MINYANVILLE ORIGINAL Over the last 60 years, the concept of risk premium has embedded itself so deeply in finance that it is hard to think of investing without relying upon it. Like the man who drinks water all his life and so thinks it has no taste, many people treat arguments based on risk premium as obvious because they have been ubiquitous in finance for so long. For example, many people wouldn’t think twice before agreeing to statements like:
- Since conservative investors prefer low-risk portfolios, assets that add a lot of risk to portfolios have to carry a higher average return than assets that are either low-risk or uncorrelated with conservative portfolios.
- Since levering an investment increases its risk, it should also increase its expected return.
- If the risk of an investment goes up and there is no change to its expected future value, its price today should go down.
Eric G. Falkenstein argues that there is no risk premium, and there never was, so conventional investing advice is deeply misguided. More important, he has developed a consistent and plausible alternative explanation. This is a very valuable argument, even if it is ultimately not correct. You cannot understand risk premium if you think it is obvious, you need to see why it might not exist to see how to look for it. And, of course, if the argument is correct, it is even more valuable.
The book also describes an investment approach, a version of what is generally called low-volatility investing. The author is among the pioneers in this area and he advocates a reasonable version of it. However you need not accept his argument to take advantage of the insights that led to the general development of low-volatility investments. There are different theories out there to explain why it works. Falkenstein, in my opinion, has the boldest plausible explanation, but even if he is correct, that doesn’t mean it leads to the best practical portfolio advice or the best investment products (of course, it also doesn’t mean the contrary). Theory is important, but implementation details like fees, expenses, taxes, execution quality, data quality, and dozens of others are more important. So just because you like this book doesn’t mean low-volatility investing is for you, and just because you like low-volatility investing doesn’t mean you have to like this book.